Earnings Call Transcript - WHF Q1 2024

Operator, Operator

Good morning. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance First Quarter 2024 Earnings Conference Call. Our hosts for today's call are Stuart Aronson, Chief Executive Officer, and Joyson Thomas, Chief Financial Officer. Today's call is being recorded, and a replay is available through a webcast in the Investor Relations section of our website at whitehorsefinance.com. If you have any questions, please feel free to turn the call over to Robert Brinberg of Rose & Co. Company.

Robert Brinberg, Analyst

Thank you, Mike, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's first quarter 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 obligation or responsibility to update any forward-looking statements. Today's speakers may refer to material from the WhiteHorse Finance First Quarter 2024 Earnings Presentation.

Stuart Aronson, CEO

Thank you, Rob. Good morning, and thank you all for joining today. As you know, we issued our earnings this morning before the market opened, and I hope you've had a chance to review our results for the period ending March 31, 2024, which are also available on our website. On today's call, I will start by discussing our first quarter results and the current market conditions. Joyson Thomas, our Chief Financial Officer, will then provide a more detailed analysis of our performance, after which we will open the floor for questions. I am pleased to announce that we have continued our strong performance for the first quarter of 2024. Our GAAP net investment income and core NII for Q4 was $10.8 million or $0.465 per share, which comfortably covered our quarterly base dividend of $0.385 per share. This shows a slight increase from Q4 GAAP and core NII of $10.6 million or $0.45 per share. The NAV per share at the end of Q1 was 13.50, indicating a 1% decrease from the previous quarter. This decrease in NAV was mainly due to net markdowns on our portfolio amounting to $5.2 million, primarily related to a markdown in equity warrants in Seagate Corporation, which I will discuss shortly. The NAV decline was partially offset by the surplus of core NII over our quarterly dividend. In terms of portfolio activity for Q1, we had gross capital employment of $55 million, with $44.7 million allocated to five new originations and the remaining $10.3 million for add-ons to existing investments, as activity remained reasonably robust. Alongside the add-ons, there were $0.8 million in net fundings for revolver commitments. Among our five new originations in Q1, two were sponsored deals and three were nonsponsored, with an average leverage ratio of about 3.5 times debt to EBITDA. All these deals were first lien loans with an average spread of 730 basis points and an average all-in rate of 12.6%. Both of these metrics are attractive from both historical and current market perspectives. During the quarter, we transferred two of these new deals and existing investments to the Ohio fund. By the end of Q1, 99% of our debt portfolio consisted of first lien senior secured loans, with a portfolio mix of approximately two-thirds sponsor and one-third nonsponsor, consistent with the prior quarter. For Q1, total repayments and sales amounted to $43.4 million, primarily due to five complete realizations and one partial realization. We anticipate that repayment activity will remain high, especially for credits that are over two years old, where call protection has diminished. In certain cases, we will consider repricing deals and assess risk and return on an individual basis as we navigate a more aggressive market environment. So far in Q2, we've observed $15 million in full repayments and sales. With repayments and joint venture transfers largely offsetting our deployment activity, the company's net effective leverage has increased slightly to 1.19x, which remains below the lower end of our target leverage range, especially as our portfolio is concentrated in first lien loans, which generally carry lower risk than second lien loans. With that context, I will shift focus to our overall investment portfolio. After accounting for net repayments and STRS joint venture transfers, alongside $0.8 million in net mark-to-market increases and $6.1 million in realized losses, the fair value of our investment portfolio stood at $697.9 million at the end of Q1. This compares to a fair value of $696.2 million at the end of the previous quarter. The weighted average effective yield on our income-generating debt investments was 13.7% as of the end of Q1, unchanged from the end of last year. We continue to successfully leverage the STRS joint venture, which generated approximately $4.8 million in investment income for the BDC in Q1, up from $4.2 million in Q4. As of March 31, the fair value of the JV's portfolio was $309.4 million, with an average unlevered yield of 12.4%, consistent with Q4. The JV currently produces an average annual return on equity in the mid-teens for the BDC, and we believe that WhiteHorse's equity investment in the JV yields attractive returns for our shareholders. Moving on to the broader BDC portfolio, there were some markdowns during Q1, particularly a $3.5 million markdown on our equity investment in Seagate Corporation. We exited the Seagate loan a few years back and received warrants for at least 17% of the company due to covenant defaults at that time, with no cash basis in these warrants. Seagate went out of business in Q1, so we marked the warrants down to zero. There were also minor markdowns in three other credits, including New Cycle Solutions, which was put on non-accrual during the quarter. The markdowns were more than offset by reversals of previous unrealized losses following the realization in Crown Brands, a second lien investment, and the restructuring of the Atlas purchaser, known as Aspect Software. We resolved the Crown Brands loan by selling it back to the sponsor running the company. Although this sale occurred at a discount, it was at a price higher than the end-of-quarter valuation. We also engaged in the restructuring of our investment in Atlas purchaser, which resulted in a realized loss. New Cycle was the only credit that shifted to non-accrual during the quarter, with non-accrual investments totaling 1.3% of our debt portfolio at fair value, compared to 2% to 2.5% at the end of Q4. Naviga is currently going through a sale process, but valuations have come in slightly below the debt's value, leading us to mark the asset accordingly. American Crafts and ArcServe remain in non-accrual status. As you may recall, we hold a controlled position in American Crafts, and we, along with other lenders, took control of Arcserve earlier in Q1. We are actively working to turn these companies around and maximize their value. The trends we see in both accounts are improving compared to a quarter ago. In general, we observe balanced activity regarding credit performance and are pleased with the overall health and relative stability of our debt portfolio. We note that cyclical accounts are performing surprisingly well, while struggling accounts primarily face consumer market challenges or unique issues we've discussed previously. We are vigilant in monitoring our companies, and we haven’t seen any demand weakness in sectors such as general industrial, B2B, healthcare, TMT, or financial services. Our portfolio is largely composed of non-cyclical or slightly cyclical borrowers, and we have no direct exposure to oil and gas, automotive, new home construction, or restaurants. The majority of our deals include strong covenant protection, and we find that private equity firms we collaborate with continue to back their credits with new cash or contingent equity as necessary. Regarding the broader lending market, lenders have become significantly more aggressive concerning credit, documentation, and pricing, continuing the trend from Q4. As Q1 progressed, we noticed a slight uptick in M&A activity from both sponsor and nonsponsor markets. Despite this increase, we still face a considerable supply-demand imbalance favoring borrowers, as direct lending firms that experienced lower volumes in 2022 and 2023 are now eager to meet their budgets and are more willing to adopt aggressive strategies. This market degradation has been most pronounced in the sponsor sector, with leverage increasing by 0.5 to 1 turn and loan-to-value ratios now at 55% to 65%. More middle-market deals are occurring with mild financial covenants, and pricing has dropped by 100 to 150 basis points since last quarter. This decline happened abruptly, and we haven't seen any recovery in Q2. In the upper mid-market, prices have fallen to the level of SOFR 450 to SOFR 525. The mid and lower mid-market are seeing deals priced around SOFR 500 to SOFR 575. Thankfully, the non-sponsor market has not seen as dramatic a shift, with credits maintaining leverage between 3 to 4.5 times and a pricing decline of only about 50 basis points. Historically, the non-sponsor market is less volatile than the sponsor market due to reduced competition and more challenging access for lenders. As mentioned earlier, many deals we conducted in 2022 and 2023 still have call protection, and we're effectively maintaining the price points achieved during those more favorable years, typically around 650 to 750 for both sponsor and non-sponsor deals. In the present market environment, we are exercising caution in our deal sourcing with active sponsors and are concentrating on the off-the-run sponsor market and non-sponsor opportunities where terms tend to be comparatively more attractive. Our access to this market enables us to secure higher prices than what is generally available in the upper mid-market or mid-market. Concerning the overall economy, recent data suggests that inflation will persist at a level higher than the Fed's target. We concur with the prevailing view that there may be between 0 to 2 rate cuts later this year. Consequently, we expect slower economic growth extending through 2024 and into 2025. The year began relatively slow regarding the pipeline, which is typical for this time of year, but we did start with a solid backlog of deals, mainly in the non-sponsor phase. Our pipeline has expanded through the first half of the year due in part to our sourcing model, which allows us to identify deals in less competitive market segments, including the off-the-run sponsor and non-sponsor markets. Our three-tier sourcing framework continues to offer the BDC exceptional capabilities, and we significantly benefit from the shared resources and partnership with HRG, a leader in the mid-market and lower mid-market space. Whitehorse employs around 22 origination professionals across 11 regional markets in North America, enhancing our origination pipeline and allowing for more conservative deal selection. After the repayment activity in Q1, the BDC balance sheet has approximately $40 million in capacity for new assets within our target leverage range. The JV has an additional $50 million capacity, complementing the BDC's existing capacity, with market seals priced below SOFR 600 aimed at the JV, while those priced at 600 or above are primarily a focus for the BDC balance sheet. We are actively engaged in 11 new mandates and add-on acquisitions from these new platform mandates, most of which are non-sponsored deals. While we cannot assure any of these deals will close, they all align with the potential for the BDC or JV should we decide to proceed. Since the quarter ended, we have successfully closed two new originations and three add-ons to current portfolio companies, with several more transactions pending. One of the new originations was transferred to the JV during the second quarter. We have also moved two add-on investments to the JV in the second quarter. In summary, activity is on the rise, and we are cautiously optimistic that the market will remain favorable for Whitehorse. Despite ongoing concerns about economic softening, we believe we are well-equipped to continue finding attractive opportunities, manage economic challenges through our diligent underwriting standards, and keep delivering value to our shareholders. Now, I will turn the call over to Joyson for further performance insights and a review of our portfolio composition.

Joyson Thomas, CFO

Thanks, Stuart, and thank you, everyone, for joining today's call. During the quarter, we recorded GAAP net investment income and core NII of $10.8 million or $0.465 per share. This compares with Q4 GAAP NII and core NII of $10.6 million or $0.456 per share and our previously declared quarterly distribution of $0.385 per share. Q1 fee income was unchanged quarter-over-quarter at $0.6 million. Q1 amounts were primarily comprised of $0.5 million of amendment fees, the majority of which came from an amendment fee from TELUS moldings. For the quarter, we reported our net increase in net assets resulting from operations of $6 million. Our risk ratings during the quarter showed that 77.6% of our portfolio positions carried either a 1 or 2 rating, slightly lower than the 77.7% in the prior quarter. As a reminder, our one rating indicates that the company has seen its risk of loss reduced relative to initial expectations, and a rating indicates the company is performing according to such initial expectations. Regarding the JV specifically, we continue to grow our investment. As Stuart mentioned earlier, in the first quarter, we transferred two new deals at one existing investment, totaling $8.5 million in exchange for cash proceeds for the same amount. Additionally, during the quarter, two existing portfolio company investments fully realized in the portfolio. And as a result, as of March 31, 2024, the JV's portfolio held positions in 34 portfolio companies with an aggregate fair value of $309.4 million compared to 34 portfolio companies at an aggregate fair value of $312.2 million as of December 31, 2023. Subsequent to the end of the first quarter, the company transferred three investments to the JV, including one new portfolio company. The investment in the JV continues to be accretive to the BDC's earnings, generating a mid-teens return on equity. During Q1, we did see an elevated amount of income recognized from our JV investment, which aggregated to $4.8 million during the quarter as compared with approximately $4.3 million in Q4 of last year. The approximate $0.5 million increase or $0.024 per share is largely attributable to nonrecurring events that occurred in the JV's portfolio. As we have 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, 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 $20.9 million at the end of Q1, including $10.2 million in restricted cash and approximately $135 million of undrawn capacity available under our overall credit facility. As of March 31, 2024, the company's asset coverage ratio for borrowed amounts as defined by the 1940 Act, was 179.5%, which was above the minimum asset coverage ratio of 150%. Our Q1 net effective debt to equity ratio after adjusting for cash on hand was 1.19x compared with 1.16x for the prior quarter. Before I conclude and open up the call to questions, I'd again like to highlight our distributions. This morning, we announced that our Board declared a second quarter distribution of $0.35 per share, which is consistent with the prior quarter. The upcoming distribution, the 47th consecutive quarterly distribution paid since our IPO in December 2012, with all distributions at or above a rate of $0.355 per share per quarter will be payable on July 2, 2024, to stockholders of record as of June 18, 2024. 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 now turn the call over to the operator for your questions.

Operator, Operator

We have our first question from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Just one quick question for me. With the movements in non-accruals this quarter, was there any impact on interest income in terms of recaptures or reversals of previous interest income?

Stuart Aronson, CEO

Joyson, I'll leave that for you.

Joyson Thomas, CFO

Mickey, we did not reverse out any income accruals during the period. We just ceased from recognizing any additional accruals during Q1.

Operator, Operator

And we do have our next question from Bryce Rowe with B. Riley.

Bryce Rowe, Analyst

I wanted to follow up on some of the prepared remarks. You talked about, obviously, spreads and pricing having come in, more aggressive terms and conditions out there in the market. And you did talk about evaluating whether you would follow some credits that we're at least exploring some kind of refinance option. Curious what would kind of keep you in the credit and what kind of pricing deterioration would you see relative to what's on the books right now?

Stuart Aronson, CEO

To provide two examples, we were involved with a company that had industrial cyclicality and received an offer for a deal with higher leverage and a 100 basis points lower price. While we might have agreed on the price, the increased leverage in a cyclical setting made us uneasy, leading us to exit that credit. In contrast, we have another company in the business services sector where the prepayment penalties have expired and the company has performed well, reducing its leverage by more than a turn since closing. To retain that asset, we will need to lower the pricing from SOFR 625 or 650 down to SOFR 525. However, due to the strong performance of the asset, which is non-cyclical with low capital expenditures, we are prepared to accept the lower price. Our decision will mainly be influenced by credit concerns and market aggressiveness. Currently, the market is in the 500 to 575 range in the mid-market and lower mid-market segments, and we are willing to accept those prices for credits that we believe are strong and stable.

Bryce Rowe, Analyst

Okay, that makes sense. Can you discuss your internal watch list within Whitehorse and how it impacts the internal risk ratings? What are you observing that is influencing changes in credit ratings? I'm trying to understand the potential risks within the portfolio and whether these risks are increasing in this prolonged higher interest rate environment.

Stuart Aronson, CEO

Yes. The average leverage on our deals is and has been modest. So the higher rate environment is not in and of itself causing us much concern. We do, as we've indicated in the ratings on the deals and the marks you see on the deals have a number of credits that are underperforming to the original plan. That results in a mark of 3 or a rating of 3, some where we're concerned about losing principal amounts. Those are ratings of 4. And as I mentioned in my prepared remarks, there is no broad trend other than consumer-facing companies being weaker. There's no broad trend that we're seeing in terms of reasons why companies are underperforming. In some cases, it's ArcServe had a technology outage and lost customer data a couple of years ago. and that has led to us taking over the company and trying to turn it around other credits that we're dealing with are dealing with the idiosyncratic issues. We are not seeing broad economic weakness at this point. And we would tell you that the revenues for companies across the portfolio on average are up, partially due to inflation, but partially due to reasonably strong demand in the general business market.

Bryce Rowe, Analyst

Okay. That's helpful. Last one for me. You mentioned some comments about the new cycle going through a sale process and possibly facing a lower valuation than expected. Can you discuss the factors involved in handling this within your portfolio and whether you have to sell or hold onto it?

Stuart Aronson, CEO

Thankfully, it's a very small investment, and the situation involves a sponsor that owns the company putting it up for sale after receiving an offer they are attempting to finalize. However, the offer is below the debt value. It's a club deal, and we hold a small share in this arrangement. There is no active market for that asset, so the best course of action for us is to wait for the company's sale and recover what we can from that asset, which we believe will align closely with its current valuation.

Joyson Thomas, CFO

I wanted to mention something about the new cycle, which also connects to Mickey's earlier question regarding reversals. We reversed a small fee of approximately $98,000 that was due at exit or maturity on the new cycle based on our expectations for what we anticipate collecting.

Bryce Rowe, Analyst

Okay. But that had already been accrued, Joyson? Or just...

Joyson Thomas, CFO

That's correct. It had previously been accrued based on an amendment in an earlier period and was reversed out during that time.

Operator, Operator

And we have our next question from Erik Zwick with Hovde Group.

Erik Zwick, Analyst

Just one question for me and maybe kind of a two-part question. Could you just remind me kind of the characteristics that you consider for transferring investments into the JV and the JV that just over 15% of the total portfolio at fair value today, where is your comfort range with the size of that relative to the total investment portfolio?

Stuart Aronson, CEO

Answering the second part of your question first, we believe the joint venture has reached an appropriate size with the committed capital for the BDC. We don't anticipate increasing the joint venture size any further. Depending on market conditions, we will retain higher-priced deals on the BDC balance sheet while lower-priced deals will go into the joint venture. Currently, as mentioned in the prepared remarks, deals priced at 600 or above, considered premium prices in today’s market, along with those we are obtaining on non-sponsor deals, will typically go onto the BDC balance sheet, while deals priced under 600 will generally go to the joint venture.

Operator, Operator

Our next question comes from Sean Paul Adams with Raymond James.

Sean Paul Adams, Analyst

It appears that the average investment size in the portfolio has been decreasing each quarter, which has been a trend for the past few quarters. We are now averaging around $5 million. Earlier this year, you indicated that the new average allocation target would likely be between $8 million and $10 million. Have you adjusted that target allocation range moving forward, or are anticipated add-ons influencing that number?

Stuart Aronson, CEO

I think what's really going on is a lot of the non-sponsor deals we do are smaller deals. And so the BDC's allocation into those smaller deals is ultimately a smaller number. That is just a natural result of, again, the average size of the deals that we're closing. So I would say if we see a normal market environment, I would still expect the average size of an asset going into the BDC to be more in the $8 million to $10 million range.

Operator, Operator

At this time, I’m currently showing no questions in the queue. I’ll now turn the call back over to Stuart Aronson for closing remarks.

Stuart Aronson, CEO

All right. Well, we continue to work hard to keep the portfolio as healthy as possible and to add good credits that will give the BDC stability going forward regardless of market conditions. I appreciate everybody's time today. And as always, heading into next quarter's call, if anyone has topics they want us to address in the prepared remarks, please communicate with either Joyce and their eye in advance of those calls, and we will do our best to answer questions with complete transparency. Thank you very much, and have a good day.

Operator, Operator

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