Earnings Call Transcript - WHF Q1 2022

Operator, Operator

Good afternoon. My name is Britney, and I will be your conference operator today. I would like to welcome everyone to the WhiteHorse Finance First Quarter 2022 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 will be available for replay starting at 5:00 p.m. Eastern Time. The replay dial-in number is 402-220-1122, and no passcode is required. It is now my pleasure to turn the floor over to Robert Brinberg of Rose & Co. Please go ahead.

Robert Brinberg, Speaker

Thank you, operator, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's First 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 first 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.

Stuart Aronson, CEO

Thank you, Rob. Good afternoon, everyone, and thank you all for joining us today. We issued our press release this morning before the market opened, and I hope you've had a chance to review our results for the period ending March 31, 2022, which are also available on our website. I will start by discussing our first quarter results and current market conditions, followed by a more detailed performance review from Joyson Thomas, our Chief Financial Officer, after which we will open the floor for questions. I'm pleased to report a strong first-quarter performance for 2022. Our GAAP net investment income for Q1 was $8.5 million, or $0.368 per share. After adjusting for a $0.6 million capital gains incentive fee reversal, our core net investment income was approximately $7.9 million, or $0.344 per share. At the end of Q1, our net asset value per share was $14.99, a decrease of $0.11 from Q4 2021. This decline was mainly due to realized losses from the sale of our investment in Grupo HIMA, as noted in our portfolio update press release on May 3, 2022, although this was partially offset by market adjustments from the restructuring of PlayMonster and net mark-to-market gains across the portfolio. Looking at our portfolio activity for the quarter, gross capital deployments in Q1 reached $83.6 million, surpassing our previous record for the highest level of gross deployments in any first quarter in our history. From this amount, $69.5 million was allocated to six new originations, while the remaining $14.1 million was invested as add-ons to existing portfolio investments. Gross deployments were partly offset by repayments and sales totaling $45.1 million, primarily driven by five full realizations and partial sales in several credits as we sought to create capacity and optimize our BDC's portfolio for the higher-yielding credits in our pipeline. This resulted in net deployments of $38.5 million. Consequently, at the end of Q1, our net effective leverage was 1.30x, down from 1.31x in Q4 2021. We remain modestly under our 1.35x leverage limit and well within our target range. As anticipated, many of the repaid amounts that were delayed in Q4 2021 have begun to come in. Beyond the payoffs and sales in Q1, we have already received an additional three full repayments totaling $45 million since the end of the quarter. Of the six new originations in Q1, four were sponsor deals and two were non-sponsor, with an average leverage level of 4.7x, which is quite modest compared to other middle-market lenders. It is noteworthy that all of these deals were first lien, and at the end of Q1, over 96% of our debt portfolio was first lien and 100% was senior secured. We are still looking to include second lien loans to better balance our portfolio but have found few that align with our conservative risk-return criteria. Currently, our portfolio contains approximately 3.5% second lien loans compared to our target of up to 15%. As I've mentioned in the past, while our portfolio is heavily concentrated in first lien loans, we expect to maintain the BDC's leverage around 1.35x to assist in consistently earning our $0.355 quarterly dividend. To provide a broader view of our entire investment portfolio, we saw strong net originations in the quarter, but the fair value of our investment portfolio was $800 million at the end of Q1, down from $819 million at the end of Q4 2021. This decrease was due to asset transfers to the STRS joint venture, partially offset by net mark-to-market increases in our portfolio. Our weighted average effective yield on income-producing investments was 9.2% at the end of Q1, slightly above the Q4 level of 9.1%. We're happy to report that we had no debt investments on non-accrual status as of the end of Q1, thanks to our decision to exit our distressed investment in Grupo HIMA and our restructuring efforts in PlayMonster during the quarter. As disclosed on May 3, 2022, we exited our position in Grupo HIMA through a sale, which led to net realized and unrealized losses of $6.9 million in Q1. Over time, after accounting for both principal and interest payments, we recovered about 75% of the capital invested in Grupo HIMA, marking a rare credit loss in our BDC's history. Although we are disappointed with the outcome of this investment, we determined it was best to exit the deal amid a complex situation involving several contingent liabilities and instead concentrate our efforts on managing our directly originated assets that make up the majority of our portfolio and pursuing future originations. Regarding PlayMonster, as mentioned during the last call, WhiteHorse and another lender took control of the company. The PlayMonster deal was restructured in Q1, replacing our previous loan with a new interest-bearing term loan and additional preferred and common equity. We expect turning around the company and exiting will take several years, but we remain optimistic about achieving a strong recovery over time. Thanks to the HIG Capital family, we have access to private equity professionals who can assist us in managing this investment. At the end of Q1 2022, we've noticed some improvements which allowed us to adjust the investment value to 75% of our cost basis from 65% at the end of Q1 2021. Most of our portfolio companies are handling supply chain and labor challenges effectively and have been able to pass cost increases on to customers. Given the modest leverage levels that we underwrite our loans to, both from an EBITDA and an operating cash flow perspective, we expect that most of our portfolio companies will be able to service our debt despite rising interest rates. Our investment portfolio is well-positioned to gain from these increasing rates, as roughly 99.6% of our debt portfolio consists of floating-rate debt investments. We believe the conservative nature of our underwriting process, which includes maintaining modest leverage levels for our loan investments, distinguishes us from lenders with higher-leverage portfolios who may struggle to service their debts as interest rates climb. Additionally, our joint venture with STRS Ohio has been successful, generating approximately $2.6 million in investment income for the BDC in Q1, up from $2.2 million in Q4 2021. In the first quarter, we transferred $82.7 million in investments to the STRS JV, comprising six new deals, five add-ons, and portions of three previously transferred deals for cash of $57.7 million and $25 million in-kind investments into the JV. As of March 31, the fair market value of the JV's portfolio was $312.8 million, with an average unlevered yield of 7.9%, consistent with the Q4 2021 average yield which was also 7.9% with a portfolio size of $259.5 million. The JV's portfolio currently comprises only first lien senior secured loans, and we are pleased with the income contribution from this venture, which has yielded an average annual return on equity in the low teens. We believe this JV contributes to higher returns for our shareholders and is especially relevant given the current market context. As mentioned during our last call, we closed an additional $25 million commitment to the JV at the start of Q1, which provided around $62.5 million in additional investment capacity. However, as stated in our prior earnings call, nearly all this extra capacity has already been utilized, showcasing the continued strength of our origination activities. Given the JV's return on equity, we are considering further funding commitments to the JV as we seek to enhance our exposure to this profitable earnings stream. Meanwhile, the market remains active, and we have a strong pipeline for future deals. The sourcing process is still competitive, especially for prominent sponsor deals, where pricing leverage and documentation terms have reverted to pre-COVID levels despite macro pressures like inflation and international conflict. Documentation terms and EBITDA adjustments in the smaller sponsor market are less aggressive compared to larger sponsors. We continue to leverage our presence in 12 regional markets to gain significant advantages in off-the-run sourcing. Consistent with previous quarters, competition remains lower for non-sponsored deals, allowing us to source attractively-priced transactions at conservative leverage levels. While we anticipate high activity levels in our pipeline, we maintain a cautious outlook and continue to underwrite based on conservative downside scenarios, including the potential for a recession within the next 12 months. So far in Q2, the company has completed two transactions and currently has visibility on over eight additional new deals and add-on transactions, though we cannot guarantee that all will close. This substantial growth in our pipeline and these mandated deals are positioning the BDC for portfolio growth and expanding our investment in the JV, ultimately leading to higher income and greater coverage of our dividend. However, it is important to note that our platform has more origination activity than our BDC can handle, and as we aim to source higher-yielding loans, some of the pipeline deals may not fit into the BDC's portfolio as we manage our leverage target of a maximum of 1.35x or lower. Consequently, the BDC has declined four origination opportunities in the first quarter due to capacity constraints. In conclusion, we are in a good position to continue carrying out our three-tiered sourcing approach and strict underwriting standards for the rest of the year and beyond, with a strong focus on identifying higher-yielding opportunities that can generate additional investment income to support our dividend further. Overall, our portfolio remains of very high quality and in good health. As we close the first quarter, we are quite optimistic about the future. While we remain cautious about cyclical sectors, the ongoing impacts of the pandemic, the war in Ukraine, and the competitive state of credit markets, we are confident in the strength of our team and the effectiveness of our sourcing and underwriting process. Additionally, the extra capital we raised late last year, the incremental contributions to the JV, and the full impact of earnings from our Q1 deployments provide a solid foundation for our financial performance going forward.

Joyson Thomas, CFO

Thanks, Stuart, and thank you all for joining today's call. During the quarter, we recorded GAAP net investment income of $8.5 million or $0.368 per share. This compares to $7.5 million or $0.331 per share in the fourth quarter of 2021. Core NII was approximately $7.9 million or $0.344 per share after adjusting for a $0.6 million capital gain incentive fee reversal. This compares to Q4 2021 core NII of $7.3 million or $0.322 per share and a quarterly distribution of $0.355 per share. Q1 fee income increased slightly quarter-over-quarter to $0.5 million from $0.3 million in Q4. The increase was due to higher prepayment amendment activities during the current quarter. For the quarter, we reported a net increase in net assets resulting from operations of $5.7 million, which is a $2.6 million increase from Q4 '21. Our risk ratings during the quarter showed that 90.1% of our portfolio positions carried either a 1 or 2 rating, consistent with the prior quarter. As a reminder, a 1 rating indicates that the 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, we've continued to grow that investment. As Stuart mentioned earlier, we transferred 6 new deals, 5 add-on transactions and the remaining portion of 3 previously transferred deals, aggregating to approximately $82.7 million in exchange for a net investment in the JV of $25 million as well as cash proceeds of approximately $57.7 million. As of March 31, 2022, the JV's portfolio consists of positions in 33 portfolio companies, with an aggregate fair value of $312.8 million compared to 28 portfolio companies at a fair value of $259.5 million in Q4 '21. The investment in the JV continues to be accretive to the BDC's earnings. 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, 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 $21.3 million at the end of Q1, including $18.8 million in restricted cash and approximately $51.2 million of undrawn capacity under our revolving credit facility. During Q1, we amended the terms of our revolving credit facility to permanently upsize the credit facility to a total commitment size of $335 million. This provided us significant flexibility as we accounted for timing differences between anticipated prepayments and originations. And we still have a remaining core future upside of the credit facility to a total of $375 million should we so choose. As of March 31, 2022, the company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 173.4%, which is above the minimum asset coverage ratio of 150%. Our Q1 net effective debt-to-equity ratio after adjusting for cash on hand was 1.30x as compared to 1.31x in the prior quarter. Before I conclude and open up the call to questions, I'd like to highlight our distributions. On March 3, 2022, we declared a distribution for the quarter ended March 31, 2022, of $0.355 per share to stockholders of record as of March 25. The dividend was paid on April 4, 2022, marking the company's 38th consecutive quarterly distribution. This speaks to both the consistent strength of the platform as well as the resilient sourcing capabilities and ability to create a well-balanced portfolio, generating consistent current income. Finally, this morning, we announced that our Board declared a second quarter distribution of $0.355 per share to be payable on July 5 to stockholders of record as of June 20, 2022. This will mark the company's 39th 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 now turn the call back over to the operator for your questions.

Operator, Operator

We will take our first question from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

I want to start by thanking you for the depth of your prepared remarks, Stuart, because it allows us to focus on the bigger picture without having to ask all these housekeeping questions. So with that in mind, Stuart, given your long track record in the credit markets, I'd really be interested in hearing your outlook for the rest of this year and going into next year in terms of the default environment considering all the headwinds that we're facing in the credit markets.

Stuart Aronson, CEO

Yes, Mickey, good day, and a great question. It's a complicated question. I would tell you that there are numerous headwinds that everyone is aware of, rising labor costs, rising raw material costs, rising transportation costs; anything with oil as an endpoint is impacted there. While we have no direct exposure to Russia or Ukraine, it turns out, one of our companies uses a type of cooking oil that primarily came out of Eastern Europe and prices of that cooking oil have been impacted by the war. So they're now switching to different cooking oils and trying to deal with that. So there are many headwinds, but what we're seeing across our portfolio, in almost every single company, is that those rising costs and headwinds are being absorbed by price increases that are being pushed through. So I do believe we are in an inflationary spiral. I don't see it slowing down yet based on what's going on in our portfolio. We have one portfolio company in the food business that is currently pushing through its fourth price increase, and the price increases have all been reasonably significant. At WhiteHorse, based on the insights that we get from our parent company, HIG, we do think that there is a real risk of a recessionary environment, in both Europe and then ultimately, the U.S., although Europe seems to be ahead of the U.S. in terms of that. Ahead meaning more pressure in Europe. And we are underwriting all of our transactions to the possibility or even likelihood of a recessionary environment within 12 months. That means that since others are not doing that and others are not doing that, we are, at the moment, pretty uncompetitive on companies that are cyclical or even moderately cyclical. We've had a lot of those deals come in where the leverage we offered was significantly lower than what we're seeing going on in the marketplace. And so we are surprised that some number of our competitors do not seem to be underwriting to a cyclical downturn even though we are. Right now, we are focused on doing companies that are non-cyclical or lightly cyclical, and we have a solid pipeline of those transactions. And then importantly, in the face of the pressure of rising interest rates, the average leverage we put on our deals historically is in the mid-4s on an EBITDA basis and the mid-5s on a cash flow basis. And so whether LIBOR or SOFR is at 50 basis points or 350 basis points, those companies, in general, should be able to service our debt without any problem. It's companies that take on leverage of 6.5, 7.5, 8.5x that have a lot more exposure to rising interest rates. So we think our strategy of modest loan to value, modest leverage, and again, leverage not only on an EBITDA basis but on an operating cash flow basis, has been preparing us well for what we see going on right now and what we expect to happen in the coming years. In terms of defaults linked to inflation, there's nothing that we see on the horizon right now. Companies in our portfolio are dealing with their individual credit realities. But in the case of an inflationary environment, again, virtually every company has had success in passing through price increases. Most of the companies are, as Joyson indicated, performing pretty well.

Mickey Schleien, Analyst

I appreciate that explanation, Stuart. It's really helpful. And to follow up on your answer. You have 3 companies whose debt investments would seem to be on credit watch, PG Dental, Crown Brands and SureFit. Is there anything thematic amongst those 3 related to your comments about inflation and cost inputs? Or are these more idiosyncratic issues to those 3 companies?

Stuart Aronson, CEO

PG Dental dealt with issues during COVID and is still dealing with labor issues that the owners of the company are trying to resolve. The owners of that company have continued to support the company with additional equity. And so we feel good about the ownership and their support. Crown serves commercial kitchens. Restaurants are, of course, doing much better, but they also serve the commercial kitchens of hotels and cruise lines. And hotels and cruise lines have not returned to normal yet. So that company continues to have pressure on the cash flows, although they're doing much better than they were during the depths of COVID. The owner there has also supported the company with increased equity commitment as recently as the first quarter. And SureFit is a company that sells to brick-and-mortar retailers and has had some supply chain issues. They have passed through price increases. As I indicated, virtually all the companies have, but they are dealing with supply chain limitations on the timing of product arrival, and that has had some impact. So one way or another, it all relates back to COVID supply chain labor, but they are very different situations among the 3.

Mickey Schleien, Analyst

I understand. My last question relates to your comment about the lack of second liens. When we consider the broad HIG platforms, are there opportunities for the BDC to possibly add another vertical? This could include areas like equipment finance, asset-based lending, or even investing in CLO equity, which is generating very high cash flows right now. Is there any chance of these developments occurring, or will you simply continue with your current strategy and wait for the market to improve?

Stuart Aronson, CEO

Well, Mickey, we're largely out of investing capacity in the BDC. So any new initiative that was targeted, putting a lot of assets on the books would be very difficult. Equipment lending and ABL, we don't think that the returns are particularly attractive in those sectors right now from what we see. There's plenty of competition and pricing has been bid down. We see the best ROE that we're getting being the JV. We are getting low to mid-teens returns out of the JV. And as the BDC is full, we are no longer putting any assets with 500 pricing, 550, 575 into the JV at all. And the JV is now positioned to take on higher-returning assets, with spreads from LIBOR 600 to LIBOR 650. So if anything, I would say if we have available capital, we may allocate a little more capital into the JV and increase the JV cash flows, which, as you've seen, have grown strongly and have been a stable source of increased earnings for the BDC investor.

Mickey Schleien, Analyst

Yes, they certainly have, and congratulations on that performance. Stuart, those are all my questions this afternoon.

Stuart Aronson, CEO

Thank you, Mickey.

Operator, Operator

We will take our next question from Bryce Rowe with the Hovde Group.

Bryce Rowe, Analyst

Maybe just a follow-up to the discussion around the JV. And obviously, it's growing as a percentage of your portfolio and certainly appreciate the ROE, is there a level at which you start to get uncomfortable with the size of the JV relative to the overall portfolio?

Stuart Aronson, CEO

The JV is well diversified. The JV consists entirely of senior secured assets. So the JV as an investment vehicle is very consistent with the investing philosophy of the BDC. The only thing that is ultimately a pressure point is the 30% bucket for assets of that type that aren't compliant with the overall guidelines of BDC investing. As a result, there's a little more money because we want to leave a big cushion; there's a little more money that we'd be willing to consider putting towards the JV, probably something in the range of $15 million to $25 million. But after that, we believe the rest of that as cushion for the 30% bucket. But again, the JV as an entity is very consistent with our investing philosophy and very accretive for the shareholders of our BDC.

Bryce Rowe, Analyst

Okay. Yes, makes sense. Let's see. Let's maybe shift to the rate environment and the impact on the BDC. When you look at your portfolio, can you remind us where the weighted average floor is in the portfolio? And at what point do you start to see some positive impact from higher rates?

Stuart Aronson, CEO

Joyson, that's all yours.

Joyson Thomas, CFO

Bryce, regarding the weighted average floor rate in the portfolio, it has remained stable over the past few quarters. It is slightly above 1%, currently at 1.03% to 1.04%. To consider this, for every 100 basis points increase, we expect a net interest income contribution of approximately $4.9 million. This figure includes the extra interest income earned on our portfolio, minus the additional interest expense related to our credit facility.

Bryce Rowe, Analyst

Okay. Joyson, is the impact delayed? So this increase above your average floor in the second quarter will start to show in the second half of this year?

Joyson Thomas, CFO

Yes, I think there's a way to look at it. A good portion of our portfolio does reset on a quarterly basis.

Bryce Rowe, Analyst

Yes. I think that's all from me. I appreciate the insights, Stuart and Joyson.

Stuart Aronson, CEO

Again, we try to get feedback from all of you to understand what you want to hear from us, and please continue to let us know so we can include as much transparency as possible in the public comments.

Operator, Operator

We'll take our next question from Robert Dodd with Raymond James.

Robert Dodd, Analyst

On repayment activity. Obviously, last quarter, you talked about elevated prepayment income in the first half of the year. Obviously, that didn't happen in Q1 with the market volatility, et cetera. Some of that seems to have happened in Q2. You've already had $45 million in repayments. Do you expect kind of the same amount of prepayment income you were previously thinking, which you didn't give us a number, but conceptually concentrated in Q2? Or do you think the environment is going to result in some borrowers waiting even longer or just sitting on that current structures and not prepaying at all given where the market is right now?

Stuart Aronson, CEO

I think it's the latter. We have seen several transactions, some private market and some involving SPACs that have unwound due to market conditions. I think the pace of prepayments that we might have seen in 2022 will be muted compared to what they might have been based on a series of things that are going on in the market right now that are leading to less stability. I think we're going to still have a normal repayment stream. And in a normal year, about 3% of the assets in our pool repay. And so I think that is a guess, but a decent guess for what we'll see over the course of 2022.

Robert Dodd, Analyst

Got it. Following up on Bryce's question before I get to more conceptual points. Regarding the NII sensitivity, just from your sale, which is the difference between interest income and interest expense. So does the sensitivity you provided, that 4.9, not include the potential effect of increased income from the JV, which structurally is the same and would benefit the BDC if rates were to remain at the levels indicated by the forward curve?

Joyson Thomas, CFO

Robert, that's correct. So this is looking at the BDC portfolio and not necessarily underlying to the JV. And so there would be further kind of excess when looking at the JV portfolio relative to its credit facility. And then obviously, in terms of just the time you need to get that income repatriated up to the BDC.

Robert Dodd, Analyst

I understand, and I appreciate your insights. For my last question, Stuart, regarding your outlook, you've clearly mentioned the possibility of a recession. Thank you for the details you've provided. When we examine the forward curve, it has improved slightly, but it does not seem to indicate any significant reduction for 2023 or beyond. What do you believe is the likelihood that by 2023, we could experience a recession, and the Federal Reserve might have reverted its actions, resulting in Fed funds at 50, compared to where we seem to be heading by the end of the year? I know this is a vague inquiry, but any insight would be valuable.

Stuart Aronson, CEO

We acknowledge the existence of forward curves, but their accuracy can be inconsistent. Therefore, we are taking a cautious approach to potential downturns. We believe that investors in the BDC prefer stability, which is why 96% of our portfolio consists of senior secured first lien loans. We have always prepared for a scenario similar to the Great Recession occurring within a couple of years after making a deal, and we currently feel we might be closer to that possibility than we have been in previous times. We're factoring in this modeling for as early as next year. If that situation arises, the Federal Reserve's response may depend on inflation trends. There are articles discussing the risk of stagflation, which is a downside risk we are mindful of, although we hope it does not come to pass. In summary, we view forward curves as just one potential outcome and tend to adopt a more cautious perspective than what those curves might suggest.

Operator, Operator

We have no further questions on the line at this time. I will turn the program back over to our presenters for any additional or closing remarks.

Stuart Aronson, CEO

Great. Well, I thank everyone for taking the time to listen in and ask questions. And as always, as we prepare remarks for future quarters, if there are things that you'd like to hear as a part of the prepared remarks, please let us know before the call. That's both to the analysts and to the public investors. We're working hard to build a stable, safe portfolio that earns the dividend on a quarterly basis. And we will continue to do our best to deliver to our shareholders. Thank you very much.

Operator, Operator

This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful day.