WhiteHorse Finance, Inc. (WHF) Q3 2022 Earnings Call Transcript

Good afternoon. My name is Shelby, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Third 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 402-220-2655. 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 Robert Brinberg of Rose & Company. Please go ahead.

Thank you, operator, and thank you everyone for joining us today to discuss WhiteHorse Finance’s third 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 third quarter 2022 earnings presentation, which is posted to our website this morning. With that, allow me to introduce WhiteHorse Finance’s CEO, Stuart Aronson. Stuart, you may begin.

Thank you, Robert, and good afternoon. Thank you all for joining 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 September 30, 2022, which can also be found on our website. On today’s call, I’ll begin by addressing our third 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 call for questions. This afternoon, I am pleased to report solid third quarter performance for 2022. Q3 GAAP NII was $9.8 million or $0.42 per share. Core NII was approximately $8.6 million or $0.372 per share after adjusting for a $1.1 million capital gains incentive fee reversal, more than covering our quarterly dividend of $0.355 per share. NAV per share at the end of Q3 was $14.76, representing a $0.19 decrease from the prior quarter, primarily the result of mark-to-market reductions rather than actual losses on investments. The marks on our portfolio reflect market pricing that has adjusted due to disruptions in the debt markets. Turning to our portfolio activity for the quarter, gross capital deployments in Q3 totaled $39.5 million. Of this amount, $26.1 million was funded into three new originations and the remaining $13.4 million was funded into seven add-ons to existing portfolio investments. In addition to the add-ons, there was $0.6 million in net fundings made on revolver commitments. During Q3, total repayments and sales were $36.3 million, primarily driven by three complete realizations, which largely offset the BDC’s origination activity, leading to net deployments of $3.8 million for the quarter. With originations slightly outpacing repayments, net effective leverage increased to 1.22 times at the end of Q3 compared with 1.18 times at the end of Q2. At this leverage level, we remain slightly below our target range of 1.25 to 1.35. As I shared on the last call, as long as our portfolio remains heavily concentrated in first lien loans, which have lower risk but also lower returns than second lien loans, we expect to continue to run the BDC at up to 1.35 times leverage to help the BDC earn its $0.355 dividend each quarter, which we have consistently distributed since our IPO. Regarding the three realizations, we earned $16.3 million, including interest and fees, which generated an aggregated IRR of 12.1% on the $48.1 million of aggregate capital invested into these first lien deals. This attractive return for senior secured loans demonstrates the power of our sourcing model in the lower mid-market, confirms our diligent and conservative selection process, and highlights our ability to negotiate tight covenants and strong call protections. Third quarter realizations included Mills Fleet Farm, Nelson Worldwide, and Maxitransfers Blocker Corp. Following these repayments, the BDC had nearly $35 million of investment capacity. Thus far in the fourth quarter, there have been three full realizations. Fourth quarter realizations included $30 million in proceeds from three portfolio companies, which generated $1.7 million in prepayment penalties. Given the change in marketplace pricing, which I will discuss shortly, we believe that repayment of historical investments may allow WhiteHorse to redeploy capital into higher yielding investments. Of our three new originations in Q3, all were sponsor deals with an average leverage of 4.3 times, relatively modest compared to other lenders in the marketplace. I note that all these deals were first lien loans and had an average expected all-in rate of 9.4% with an effective yield of 12%, higher than the Q2 portfolio average. At the end of Q3, 96.8% of our portfolio was first lien and 100% was senior secured. With that in mind, I’ll now step back to bring our entire investment portfolio into focus. After $7.5 million in net mark-to-market decreases, $0.2 million in unrealized gains, and $1 million of accretion, the fair value of our investment portfolio was $764.6 million at the end of Q3, down marginally from $766.5 million at the end of Q2. The weighted average effective yield on our investments was 11.4% as of the end of Q3, reflecting a 150 basis-point increase from Q2's level of 9.9%. The increase was primarily driven by a rise in the portfolio’s base rate due to rising LIBOR and SOFR rates. Transitioning to the STRS Ohio joint venture, we continue to utilize our JV successfully. The joint venture generated investment income to the BDC of approximately $3.8 million in Q3, compared with $3 million in Q2. This increase was driven by higher interest and dividend income from the JV in Q3. As of September 30, the fair market value of the JV’s portfolio was $280.9 million. At the end of Q3, the JV’s portfolio had an average unlevered yield of 10.1%, above Q2’s average of 8.7%. The increase in unlevered yield is primarily due again to rising base rates of LIBOR and SOFR. The JV produces an average annual return on equity in the low teens for the BDC. We believe WhiteHorse’s equity investment in the JV provides an attractive return for shareholders, particularly relevant given the current market backdrop. Given the JV’s return on equity, we are considering adding an additional commitment of $15 million to the JV as we seek to increase our exposure to this highly accretive earning stream. Returning to the BDC’s portfolio, I’m pleased to report that we continue to have no investments on nonaccrual status. We had some markdowns on the portfolio, but on average, the portfolio was stable despite continued broad market volatility in Q3. Our diversified portfolio is weathering an economy experiencing several negative factors, including rising interest rates, rising raw material prices, and rising labor costs. Across the portfolio, revenues are up, but we are seeing margin degradation on a couple of borrowers due to cost pressures. While some of our borrowers are experiencing a slowdown in consumer demand, which has led to increases in leverage, our portfolio remains mostly represented by noncyclical or light cyclical borrowers as we have no direct exposure to oil and gas, auto or restaurants, and very little exposure in the construction sector. Since we generally serve the lower midmarket, we have been able to build a portfolio with a conservative leverage profile. By keeping our portfolio 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 had only a modest impact on debt service coverage for our portfolio companies. While the portfolio is holding up very well, we are keeping a careful eye on demand characteristics, especially in the consumer sector. The modest leverage under which we underwrite our loans, coupled with the fact that almost 100% of our debt portfolio is composed of floating rate investments, has allowed our portfolio to benefit from a rising interest rate environment. We continue to monitor our portfolio companies' ability to service our debt, and with the three-month LIBOR and SOFR contracts resetting at the end of September, we anticipate continued organic earnings accretion through year-end. By contrast, lenders with higher-levered portfolio companies may face a higher percentage of their borrowers experiencing much tighter debt service as interest rates continue to increase. The market remains disrupted, with lenders concerned about economic softness, both domestically and abroad. The credit market has largely reset to levels expected during a downturn, as deals for cyclical companies are no longer being underwritten at aggressive leverage levels, and pricing for noncyclical assets have also seen an upward adjustment. Within this environment, the broadly syndicated market remains effectively shut for new issues. Nonetheless, there are residual credits that are being underwritten and are being leaked out at significant discounts. We believe some of these present attractive opportunities for investing in larger noncyclical or marginally cyclical businesses. We diligently review these loans for suitability and, with our deal flow pipeline at a record high, remain highly selective and opportunistic about which credits we pursue. Across the mid to low end of the market, the segments we are most focused on, in addition to rising prices, loans are being written with more conservative credit terms, tighter documentation, and tighter covenants. Our primary lower midmarket is still competitive with more variable pricing than the mid to upper midmarket. While the risk-return is as good as I’ve seen since 2015, we are approaching this environment with increased scrutiny and remaining focused on credits with compelling risk-return characteristics. We’re being cautious in the face of a weakening economy. Our base case assumptions are that we will see recessionary conditions in 2023 and 2024, and we want to ensure that the companies we invest in can weather the storm. In our existing portfolio, as I mentioned earlier, our investments are well positioned as they were underwritten at low leverage levels and can generally withstand even another 200 basis points of rate increases. Broadly speaking, we have already underwritten to an extreme downside scenario. Our pipeline activity remains high, and we have been selectively taking advantage of market conditions. WhiteHorse maintains its differentiated sourcing capabilities through our three-tiered architecture. The overall pipeline has increased to approximately 200 deals for the first time in the BDC’s history. We continue to derive significant advantages from shared resources and affiliation with HIG, which is a leader in the mid-market. The strength of the pipeline enables us to be meticulous in our deal selection, and the current primary limiting factor for originations is the BDC’s investing capacity. As such, as I mentioned earlier, we are considering increasing our investment in the STRS JV by $50 million. Our strategy and competitive advantages continue to result in momentum in our originations business. Thus far in Q4, the Company has closed five new deals and add-on transactions and currently has visibility for 10 additional mandated new deals and add-on transactions. Although there can be no assurance that any of these deals will close, nor can there be assurance that the BDC will have the capacity for these deals. We anticipate utilizing the capacity provided by the repayments to continue to rotate into higher yielding assets. Combined with portfolio growth and the potential for increasing our investment in the JV, this should ultimately lead to higher income and greater coverage of our dividend. At the conclusion of the third quarter, we are cautiously optimistic about the first quarter and New Year. While we remain concerned about cyclical industries and various economic headwinds, we believe we have built a very strong team and a solid sourcing and underwriting process.

Thanks, Stuart, and thank you all for joining today’s call. During the quarter, we recorded GAAP net investment income of $9.8 million, or $0.42 per share. This compares to $7.9 million or $0.339 per share in the second quarter. Core NII was approximately $8.6 million or $0.372 per share after adjusting for $1.1 million capital gains incentive fee reversal. This compares with Q2 core NII of $7.8 million or $0.334 per share, and the quarterly distribution of $0.355 per share. Q3 fee income decreased slightly quarter-over-quarter to $0.4 million from $0.7 million in Q2. The decline was due to lower prepayment amendment activities during the current quarter. In the third quarter, we reported a net increase in net assets resulting from operations of $3.8 million, a decrease of $3.5 million compared to Q2, driven by unrealized mark-to-market losses on the overall portfolio. Our risk ratings during the quarter showed that 83.5% of our portfolio positions carried either a 1 or 2 rating, slightly lower from 84.8% in the prior quarter. A 1 rating indicates that a company has seen its risk of loss reduced relative to initial expectations, and a 2 rating indicates the company is performing according to initial expectations. Regarding the JV specifically, no new assets were transferred during Q3. However, subsequent to the quarter-end, we have transferred one new portfolio company already in Q4. As of September 30, 2022, the JV’s portfolio held positions in 28 portfolio companies with an aggregate fair value of $280.9 million compared to 32 portfolio companies at a fair value of $318.8 million as of the end of Q2. The decrease in the number of portfolio companies quarter-over-quarter was a result of full realizations of positions in four portfolio companies during the third quarter. 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 factors including the timing and amount of additional capital investments, 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 $19.3 million at the end of Q3, including $9.4 million in restricted cash. As of September 30, 2022, the Company’s asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 178.7%, above the minimum asset coverage ratio of 150%. Our Q3 net effective debt-to-equity ratio after adjusting for cash on hand was 1.22 times compared to 1.18 times in the prior quarter. Before I conclude and open up the call for questions, I’d like to highlight our distributions. On August 10, 2022, we declared a distribution for the quarter ended September 30, 2022 of $0.355 per share to stockholders of record as of September 20th. The dividend was paid on October 4th, marking the Company’s 40th consecutive quarterly distribution. This speaks to both the consistent strength of the platform and our resilient deal sourcing capabilities to create a well-balanced portfolio generating consistent current income. In addition to our quarterly distribution, last month, we declared a special distribution of $0.05 per share to be payable on December 9, 2022 to stockholders of record as of October 31, 2022. The distribution was related to undistributed taxable income earned last year, which would otherwise be taxable. Finally, this morning, we announced that our Board declared a fourth quarter distribution of $0.355 per share to be payable on January 4, 2023 to stockholders of record as of December 21, 2022. This will mark the Company’s 41st consecutive quarterly distribution since our IPO in December 2012, with all distributions consistent at a rate of $0.355 per share per quarter. As we mentioned previously, we will continue to evaluate quarterly distributions in the near and medium term based on the core earnings power of the portfolio and other relevant factors that may warrant consideration.

Let’s see. Maybe I’ll start on the dividend. It’s great to see dividend coverage here in the third quarter, and I would project that with base rates continuing to rise, you’ll likely continue to earn the dividend, all else being equal. Can you kind of talk about how you think about distributing any kind of excess dividend or excess earnings above that $0.355 rate, if that does indeed emerge?

Yes. Bryce, you’ve seen for the past three years where we have excess income that would be subject to taxation. We and the Board have made the decision to distribute that income to shareholders. With rising interest rates, there is an increased likelihood that we will have earnings that would be undistributed and subject to taxation. Each year, we will carefully consider whether it makes sense to do a supplemental dividend as we did for the $0.05 this year, but that will be based on performance over the course of the year.

And then maybe just a question around credit and internal risk ratings. You highlighted a stable portfolio, maybe a slight increase in the three-rated credits. So can you walk us through what’s happening within those particular companies? And just to help us get some level of comfort with what’s going on from a credit perspective? Thanks.

Yes. Bryce, there is a clear slowdown in consumer demand and equally clear slowdown in retailers restocking inventory. We believe that inventory levels got inflated during the latter half of the COVID period, where people were not confident in supply chain and were getting as much stock on their shelves as they could. Retailers are now looking to deplete that inventory. So between consumer softness and too much inventory on store shelves, our consumer-facing accounts have seen a real and significant slowdown in demand. Uniformly, they all expect that as inventory levels get down to more appropriate levels, the retailers will start a more normal ordering pattern again. However, we are very careful about what we’re seeing in consumer demand. We are not seeing any particular slowdown in B2B. It is currently a consumer-led slowdown based on our evidence. In general, where we have seen slowdowns and where there have been covenant defaults, the owners of the companies have supported them. In the case of sponsor-owned companies, the owners have been willing to support those companies as needed with cash or contingent equity.

First question for me. From the prepared comments, I think you mentioned that you’ve had five new deals closed in Q4 and potentially 10 more in the works, no guarantee that those will close or that you’ll have capacity. My question is around how you think about the potential to not close those and/or take on additional borrowings to potentially fund those. I know you’re getting towards the top end of your targeted range now, but just curious how you think about portfolio growth going forward, especially in a period of economic uncertainty.

Yes. We are very cautious about the repayment pipeline, so we are managing the portfolio to avoid exceeding 1.35 times leverage. This means we have about $35 million of capacity, of which we are considering $15 million committed into the JV. The JV will invest in assets priced at less than SOFR 700 for the most part. The yield on those assets is now targeted more like 625 to 675. For the remaining $20 million of capacity on the BDC balance sheet, we are reserving that for assets priced at SOFR 700 or above. We regularly see SOFR 700 on assets that are modestly leveraged at 50% or less LTV and first lien senior secured loans. Just to give you an idea of the market's movement, about a year ago, second lien loans were yielding in the range of 650 to 750. Now we’re able to book first lien loans with returns of 700. We are very pleased that we did not jump into that overheated market a year ago and take on many second lien assets at spreads that today would appear unattractive. That said, we are still looking out for solid second lien investments where the market is more conservative on EBITDA adjustments and leverage levels. While our portfolio is currently 97% first lien, I would not be surprised if we find a couple of good second lien investments in noncyclical companies providing compelling risk-return for our investors over the next quarter or two.

And just looking at your funding profile, it looks like you have some notes coming due in 2023. Could you remind me what month those come due and your thoughts on how you would replace those?

Eric, those notes roll off in August of next year, totaling $30 million of unsecured paper. We’ll obviously be monitoring the market environment, but regarding the JPM credit facility, that facility has a capacity up to $335 million, allowing us to comfortably replace that $30 million with the JPM facility and stay within our 1.25 to 1.35 times target profile.

And lastly for me, just in terms of the unrealized losses you recorded this quarter. I’m curious if you could split that between how much was market spread related versus company-specific performance?

I don’t have that split, but working the numbers in my head, it was largely mark-to-market-related. I would say it was largely due to market spread, approximately one-third credit related and two-thirds mark-to-market. That sounds about right.

Okay. It sounds like definitely more market spread versus company specific. So, that's helpful.

No problem. Thank you, Erik.

I know that you talked about some of the activity in 4Q to date with some five new deals and also expecting some realizations. Did you quantify that in terms of dollars?

I don’t think we did. Joyson, do you?

Melissa, in terms of the deals originated in Q4, they relate to about three new deals and several add-ons. The total quantum is probably no more than $25 million to $30 million. With regards to the realizations, we had noted three exits during Q4 already, and proceeds aggregated to $30 million.

Okay. Thank you. I appreciate that clarification. Given your comments about the JV and the opportunity for an additional investment into that, fair to say that the growth you’ve seen in income from that vehicle should continue on that trajectory in the near-term?

Yes. If we invest more in the JV and the assets entering the JV have higher yields, both existing and new assets, the JV should continue to generate returns in the low to mid-teens. The current market environment is extremely attractive, and historically, deals were priced at 650 or 675. We’ve shifted that market, allowing us to reserve BDC balance sheets for deals priced at 700 or greater. When you combine that with rising base rates, we see a very positive trajectory in the core earnings of the BDC. Of course, that could change, but right now, the trends look very promising, which is not unique to us; I think the BDC community broadly is benefiting from the increased spreads and rising base rates.

Are you seeing any evolving metrics around PIK payments, with any borrowers trending that way as conditions get tighter? Thanks so much.

No problem, Melissa. As we reported last year, and for several years, we’ve observed in the marketplace that many lenders were providing financing at leverage multiples of 6 to 8 times EBITDA off of adjusted EBITDA without proper cash flow multiple considerations. However, with the increased LIBOR and SOFR, many companies that previously had high leverage are now finding it challenging to service their debt based on operating cash flow, which makes it more likely for them to resort to PIK payments. Luckily, we haven’t engaged much in those high-leverage deals, so we’re well positioned to keep charge on cash pay interest. Despite average leverage of around four times on our deals, we believe that even with rising SOFR, the majority of our portfolio companies will continue to meet their cash interest obligations without needing to resort to PIK payments. I appreciate everybody taking the time. As always, we are happy to provide as much transparency into our portfolio and management as we can. We invite shareholders or analysts to communicate with us ahead of these public earnings calls to let us know what type of information you would like to see. We make ourselves available to the analyst community to answer questions outside this call. Thank you very much, and we hope to share positive performance in Q4, depending on what occurs over the next few months. Thank you.

That concludes today’s teleconference. Thank you for your participation. You may now disconnect.