Earnings Call Transcript - WHF Q2 2021

Operator, Operator

Good morning. My name is Brittney, and I'll be your conference operator today. I would like to welcome everyone to the WhiteHorse Finance Second Quarter 2021 Earnings Conference Call. Our hosts for today's call are Stuart Aronson, the Chief Executive Officer, and Joyson Thomas, the Chief Financial Officer. This call is being recorded and will be available for replay starting at 4 P.M. Eastern Standard Time. The replay dial-in number is 402-220-2330, and there is no passcode required. 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 Nick Rust of Prosek Partners.

Nick Rust, Prosek Partners

Thank you, Brittney. And thank you, everyone, for joining us today to discuss WhiteHorse Finance's second quarter 2021 earnings results. Before we begin, I'd like to remind everyone that certain statements, which are not based on historical facts made during this call, including any statements related 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 2021 earnings presentation, which was posted on our website this morning. With that, allow me to introduce WhiteHorse Finance's CEO, Stuart Aronson. Stuart, you may begin.

Stuart Aronson, CEO

Thank you, Nick. Good afternoon and thank you for joining us today. As you're aware, we issued our press release this morning prior to market open, and I hope you've had a chance to review our results, which are also available on our website. I'm going to start by addressing our second quarter results and market conditions. And then Joyson Thomas, our Chief Financial Officer, will discuss our performance in more detail, after which we'll open the floor to questions. In the second quarter, core net investment income was $7 million or $0.338 per share, slightly below our dividend of $0.355. GAAP net investment income was $6.1 million or $0.296 per share. Our NII was lower than last quarter as a result of lower fee income and accelerated interest accretion, which was higher in the prior quarter due to a large volume of prepayment activity we saw in Q1. Also, as you know, asset balances were lower at the end of Q1 as a result of repayments that we received during that quarter. We achieved modest NAV accretion in the quarter generating $15.42 of NAV per share, compared to $15.27 in Q1. This gain was driven by $4 million in mark-to-market gains that we recorded in our portfolio this quarter. When adjusting for special dividends paid in prior years, our pro forma Q2 NAV per share is the highest since our December 2012 IPO. Our mark-to-market gains were highlighted by Honors Holdings at $0.7 million, Barbecue Buyer at $0.7 million, and LS GFG Holdings at $0.6 million. We also experienced a strong period for capital deployments totaling $104 million, including originating eight new transactions. This investment activity enabled us to grow the portfolio by 9% from Q1. Gross deployments of $104 million were partially offset by repayments of $31 million. We attribute the modest Q2 repayment level to the timing, as we're currently aware of a number of portfolio companies that are for sale, and if they close before year-end, this will drive an increased level of repayments. Of our eight new origination, seven were sponsor and one was non-sponsor, and the deals had an average leverage level of 4.05 times. Additionally, seven of these deals were first lien and one was second lien. At the end of the second quarter, 95% of our debt portfolio was first lien and 100% was senior security. Sponsor loans comprise 68% of our portfolio compared to 65% in Q1. We continue to be pleased with the pace of capital deployment throughout the first half of 2021 as compared to prior years, and our weighted average effective yield on income-producing debt investments of 9.5% was just slightly below the Q1 level of 9.6%. Now, stepping back to bring our entire investment portfolio into focus. At the end of the second quarter, the fair value of our investment portfolio increased to $671 million, compared to $617 million at the end of Q1. Non-accruals represented only 1.5% of our debt portfolio, compared to 2.5% on a fair value basis at the end of Q1. This decrease was driven by SureFit returning to accrual status in the quarter; Grupo HIMA remains the only non-accrual as of June 30. We remain in restructuring negotiations with Grupo HIMA and expect this process will extend for many months. We continued to successfully utilize the joint venture (JV), which generated income of $2.1 million in the quarter, the same level as Q1. The JV's portfolio size was $210 million, with an average unlevered yield of 8.1% in Q2 2021, which was slightly above the prior year period. We remain pleased with the income contributions from the JV and believe it supports higher returns for shareholders. If we use the current full capacity of the JV, we are likely to allocate an additional $25 million or more of equity into this program to continue to drive higher net interest income for WHF. As a result of the strong originations momentum, leverage at the end of Q2 was 1.14 times within our targeted range of one to one and a quarter times. Looking ahead, our Q3 pipeline is very strong, with 17 mandated deals. Eight of these deals are sponsor and split between new originations and add-ons, while the balance consists of six non-sponsor new deals, and three are non-sponsor add-ons. Given these mandates, we can confidently say that the third quarter is on pace to produce the highest origination volume we have ever generated through our platform. This exceptional pipeline growth and these mandated deals are enabling the BDC to drive portfolio growth and ramp the JV, which will ultimately lead to higher income levels and greater coverage of our dividend. Given that we expect high repayment activity during the balance of the year, we may choose to operate at a higher leverage ratio than our targeted one and a quarter times to prepare the portfolio for expected repayments. We have already had one repayment and refinancing in Q3. We expect some additional early repayments due to mergers and acquisitions in new financing events for a number of credits during the remainder of the year. This, of course, is subject to change given current market conditions. In closing, we're well-positioned to continue executing our three-tiered sourcing approach and rigorous underwriting standards in the second half of the year. Our portfolio as a whole remains very high quality and healthy, together with a strong pipeline of investment opportunities. We expect fee income to pick up in the second half, which should enable us to continue covering the dividend from core net interest income. That said, the increasing rates of COVID-19 infections and hospitalizations create uncertainty and could impact both portfolio performance and the rate of new asset origination. H.I.G. with $45 billion of capital under management empowers us to continue to benefit from the shared resources of a leader in the mid-market. This includes 63 field professionals dedicated to direct lending, a 20-plus-person business development team leveraging H.I.G Capital's proprietary prospect database and sourcing at the H.I.G level by over 400 investment professionals overall. Our WhiteHorse team spans 12 locations across North America and includes non-gateway markets that face less deal sourcing competition than large investment centers like New York and Chicago. As a result, we believe our combined platform is poised to drive continuing portfolio growth and ultimately higher returns to our shareholders across our established direct lending business. With that, I'll turn the call to Joyson, after which we'll take your questions.

Joyson Thomas, CFO

Thanks, Stuart. And thank you all for joining today's call. During the quarter, we recorded GAAP net investment income of $6.1 million or $0.296 per share. This compares to $7.6 million or $0.37 per share in Q1 2021. Core NII was $0.338 per share after adjusting for $0.9 million capital gains incentive fee accrual. Our investment in the JV continued to ramp up, increasing by $6.6 million after the effects of transferring for new deals and three add-ons that totaled $31.8 million in Q2. As of June 30, we held 25 positions in the JV with an aggregate fair value of $209.5 million compared to 22 positions at a fair value of $185.7 million in Q1. Investment in the JV continues to be accretive to the BDC earnings, as our return on investment in the JV at the end of Q2 was approaching 14%. Q2 fee income was approximately $0.3 million, compared to $0.8 million in the prior quarter. The decline was largely due to higher prepayment fees collected during the first quarter. We reported an increase in net assets resulting from operations of $10.5 million. Our portfolio review during the quarter showed that 90% of our portfolio positions carried either a one or two rating compared to 84.3% in Q1. Turning to our balance sheet, we had cash resources of approximately $17.8 million as of June 30, 2021, including $7.4 million in restricted cash. At quarter-end, we had approximately $46.5 million undrawn under our revolving credit facility. We also have the flexibility to increase the line to $350 million under an existing accordion feature. As of June 30, 2021, the company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 187.9%, which is above the minimum asset coverage ratio of 150%. Our Q2 net effective debt to equity ratio after adjusting for cash on hand was 1.08 times. Since the end of the quarter, we have completed an amendment and refinancing on our existing JPMorgan bank credit facility. The impact will extend the non-coop period to November 22, more shots of reinvestment period to November 2024, and reduce the applicable interest spread from 250 to 235 basis points beginning in Q3 2021. We anticipate this will result in annual cost savings of approximately $0.4 million, assuming the line continues to be utilized at our historical levels. Next, I'd like to highlight our distributions. On May 10, 2021, we declared a distribution for the quarter ended June 30, 2021, of $0.355 per share for a total distribution of $7.4 million to stockholders of record as of June 18. The dividend was paid on July 2, 2021, and marks the company's 35th consecutive quarterly distribution since their IPO in December 2012, with all distributions consistent at the rate of $0.355 per share per quarter. Finally, this morning, we announced our Board of Directors declared a third quarter distribution of $0.355 per share to be payable on October 4, 2021, to stockholders of record as of September 20. As we said previously, we will continue to evaluate our quarterly distribution 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 now turn the call back over to the operator for your questions.

Operator, Operator

Thank you. Now we'll take our first question from Bryce Rowe at Hovde Group.

Bryce Rowe, Analyst

Stuart, you noted that you're expecting possibly the highest-ever originations quarter here in the third quarter; I guess it could move into the fourth quarter as well. But looking back, it looks like $176 million was the best quarter for originations to date. So if you could kind of help us frame the pipeline relative to that, and then from a repayment perspective, I know it's hard to predict, but do you expect originations in the back half of this year to outpace repayment activity?

Stuart Aronson, CEO

Our originations activity across our entire WhiteHorse direct lending is higher than it's ever been, which is strange for Q3 because Q3 is normally the second slowest quarter after Q1, and that bodes well for Q4. Absent disruptions in the economy or something else, we’re not projecting. How much of that origination activity ends up in the BDC will come down to suitability for the BDC and allocation percentages. But it should be significant, I would say, based on what we know right now; we will have significant net additions to the portfolio in Q3. And then we have a number of sale processes on companies. Again, we’re not selling them; the owners are selling them, but we have our loans that will get repaid as a part of that, which will probably get into Q4. So, Bryce, what we’re hoping to do is ramp up originations, potentially get the total leverage above one and a quarter in Q3, preparing for what we expect to be more paydowns in Q4. And we're going to try to manage to about one and a quarter times leverage with assets of around $700 million for year-end if we can get there. There are always repayments that pop up that we don't know about, but the thing that's different right now is how many of those repayments are visible because we know that the companies that those loans were made to are either already in the market or are coming to market in Q4.

Bryce Rowe, Analyst

That's good detail. Maybe one more for me, then I'll jump back in the queue. But Joyson, I noticed the dividend income not related to the JV was a bit elevated here in the quarter. Can you speak to what drove that and maybe try to get a good understanding for what that might be here going forward?

Joyson Thomas, CFO

Yes, outside of the JV's dividend, we did receive some dividend income, primarily related to our core holdings, as you know, that is an equity investment, as that investment continues to have some excess cash flows. Again, from their perspective, the underlying portfolio company made a dividend out to its equity owners, and we did recognize a dividend this quarter related to that.

Bryce Rowe, Analyst

Okay. So, is that more episodic, or is it distributed to cover your tax expense?

Joyson Thomas, CFO

Yes, that's a great question. The way I would look at it is I think there is a little bit of Canadian taxes at play there. But we do envision future income streams to come from the company prior to a realization. So what I’d say is that this isn’t kind of a one-off event.

Stuart Aronson, CEO

Yes, to highlight, our call is performing well in generating cash flow, which is being distributed as equity distributions. We will continue to operate that company until we find it appropriate to sell, which may be some time in the future. We do not know the specific date.

Operator, Operator

And we will take our next question from Robert Dodd with Raymond James.

Robert Dodd, Analyst

On the portfolio today, and kind of the outlook. Thank you for covering. I mean, right now, I guess what sponsor is about two-thirds now and non-sponsor about a third. Obviously, that has not been the kind of historic mix. And you gave some color on what the mandated deals are in Q3. But I mean, would you expect that mix to come down over time? And obviously, non-sponsored deals take longer to structure, but I mean, any color on whether that's of course, a permanent shift in the mix on some non-sponsored or just a timing kind of issue in a really active market.

Stuart Aronson, CEO

I would say that broadly. While it'll vary quarter-to-quarter in terms of new originations, our portfolio is likely to stay about two-thirds sponsor and about one-third non-sponsor. The sponsor deals are harder to find and harder to underwrite. More frequently on the non-sponsor deals, the underwriting doesn't support the credit, and even though we get mandates, we don't close on the deals. That happened on a couple of non-sponsored deals last quarter, frankly. But we have a very healthy pipeline of non-sponsor deals in Q3. As I highlighted, I think of our 17 deal opportunities that are mandated, I think nine of them are either new non-sponsor deals or non-sponsor add-ons. So in any given quarter, it could be anywhere from 90:10 to 50:50, where sponsor makes up the larger number typically, but overall would expect the portfolio to remain similar to where it is now.

Robert Dodd, Analyst

Got it. Thank you. Just to that point, I mean, that you said, I mean, you've got 17 mandated deals, roughly half sponsor. Just had a couple of sponsor mandates kind of fell through last quarter. Non-sponsored, yes. How confident are you? I mean just looking at Q2, Q3, obviously leverage going up and then leverage going back down again. I mean, what would you say your comfort level is on being at that $700 or so one and a quarter turns at year-end, given there are a lot of moving parts? If you've got higher confidence in originations, than repayments, which are more difficult to predict, or vice versa?

Stuart Aronson, CEO

I have more confidence in Q3 because we're in the middle of it and we have the mandated deals. I can look at each of the deal names and sort of handicap the likelihood of them getting done. I think our asset balances are likely to rise for a total asset portfolio to $700 million or greater in Q3. And then, in Q4, we don't yet have visibility into originations. There’s only one deal mandated right now that will be Q4 close. And we know a lot of deals are repaying in Q4. So we're going to need to look at the portfolio of pipeline deals develop over the next 16 weeks, to get more insight into Q4. But all I can tell you historically, as I mentioned earlier, Q3 is the second slowest quarter. With a Q3 this strong, absent something happening in the marketplace, we'd expect a similarly strong Q4, and that would bode very well for the JV and the core BDC portfolio balances and set us up to hopefully comfortably earn our dividend unless there are other things that go on that we don't know about yet.

Robert Dodd, Analyst

Understood. I appreciate that. Thank you. So, one housekeeping quick one if I can. The tax expenses in the quarter were a little bit elevated. Was that related to the dividend income? You mentioned that some Canadian tax considerations? I mean, and should we expect that excise tax to that tax not just to pop up if there's increased dividend income, or was it unrelated to that?

Joyson Thomas, CFO

Robert, the way I think about it is, listen, with any year, you look at our taxable income, which takes into account all the bulk tax timing differences. Ultimately, distributions are going to be paid out of taxable earnings. So when you blend all that together effectively, we currently estimate the earnings of the BDC to be in excess of our distributions at a slightly higher run rate than we were earlier in the year or last year for that matter, based on not only kind of the investment income but also some of the net gains that we're realizing this year. So, as you're aware year-to-date, we have a large realized gain from the underlying portfolio that came into play there.

Operator, Operator

And we'll take our next question from Sarkis Sherbetchyan with B Riley.

Sarkis Sherbetchyan, Analyst

Just a quick question. If you expect second half 2021 repayments to remain elevated, how does it impact fee income expectations?

Stuart Aronson, CEO

There should be either more prepayment penalties or more fee sweeps associated with faster repayments, which all things being equal will be accretive to NII. We saw that last quarter where fee suites and prepayment penalties helped us generate an NII number in excess of the dividend.

Operator, Operator

And we have no further questions on the line at this time, I will turn the call back over to management for any additional or closing remarks.

Stuart Aronson, CEO

I appreciate everyone's time and attention today. As always, if there are questions that people would like to see addressed in future calls, please alert us prior to the call so we can add that into the prepared remarks. And with that, I hope everybody has a good afternoon. Thank you.

Operator, Operator

This does conclude today's program. Thank you for your participation. You may disconnect at any time.