WhiteHorse Finance, Inc. (NASDAQ:WHF) Q3 2022 Results Conference Call November 14, 2022 1:00 PM ET
Company Participants
Stuart Aronson – CEO
Joyson Thomas – CFO
Robert Brinberg – Rose & Company
Conference Call Participants
Bryce Rowe – B. Riley
Erik Zwick – Hovde Group
Melissa Wedel – JP Morgan
Operator
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. [Operator Instructions]
It is now my pleasure to turn the floor over to Robert Brinberg of Rose & Company. Please go ahead.
Robert Brinberg
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.
Stuart Aronson
Thank you, Robert and good afternoon and thank you all for joining today. As you are aware, we issued our press release this morning prior to market open. And 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 after adjusting for $1.1 million capital gains incentive fee reversal was approximately $8.6 million or $0.372 per share, and more than covered our quarterly dividend of $0.355 per share. NAV per share at the end of the Q3 was $14.76, representing a $0.19 decrease from prior quarter. This decline was primarily the result of mark-to-market reductions, rather than any actual losses on investment. The marks on our portfolio reflect market pricing that is 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, these 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 leveraged increased to 1.22 times at the end of Q3 as compared with 1.18 times at the end of Q2. At this leverage level, we remain slightly below our we remain slightly below our target range of 1.25 to 1.35. As I shared on the last call, so long as our portfolio remains heavily concentrated in first lien loans, which have lower risk, but also lower returns in second lien loans, we expect to continue to run the BDC at up to 1.35 times leverage in order to help the BDC earn its $0.355 dividend each quarter, which we have — and we’ve consistently distributed that dividend since our IPO.
Regarding the three realizations, we earned $16.3 million, including interest in 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, 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. And these realizations 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, which is relatively modest when 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%, which was 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 unrealized gains and $1 million of accretion, the fair value of our investment portfolio was $764.6 million at the end of the third quarter, 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 the third quarter, which reflects 150 basis-point increase from Q2 level of 9.9%. The increase was primarily driven by a rise in the portfolio’s base rate as a result of 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 as compared with $3 million in Q2. This increase was driven by higher interest and dividend income from the JV in Q3. As of September 30th, the fair market value of the JV’s portfolio was $280.9 million. And 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 annual — average annual return average annual return on equity in the low teens to the BDC. We believe WhiteHorse’s equity investment in the JV provides attractive return for shareholders and is 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 as I mentioned earlier, but on average the portfolio was stable despite continued broad market volatility in Q3. Our well diversified portfolio is weathering an economy experiencing a number of 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 hold no direct exposure to oil and gas, auto or restaurants, and very little exposure in construction sector.
Since we generally serve the lower midmarket, we have been able to build a portfolio with 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 to which we underwrite our loans, coupled with the fact that almost 100% of our debt portfolio is comprised of floating rate investments has allowed our portfolio to benefit from a rising interest rate environment. We continue to monitor our portfolio company’s ability to service our debt, and the three-month LIBOR and SOFR contracts, having reset at the end of September, we anticipate continued organic earnings accretion through year-end. By contrast, lenders with higher levered portfolio companies may experience a higher percentage of their borrowers facing much tighter debt service as interest rates continue to increase.
The market remains disrupted, with lenders concerned about economic softness domestically and abroad. The credit market has largely reset to levels that one would expect to see in a downturn, 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 underwritten and are being leaked out at significant discounts. We believe some of these provide attractive opportunities for making investments and 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 to more conservative credit terms with tighter documentation and tighter covenants. Our primary lower midmarket is still competitive with pricing more variable than the mid to upper midmarket. While the risk return is as good as I’ve seen, really since 2015, we are approaching the environment with increased scrutiny and remain 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 to our three tiered architecture. The overall pipeline is increased to approximately 200 deals for the first time in the BDC’s history. And we continue to derive significant advantages from the shared resources and affiliation with HIG, who 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, and 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 capacity for these deals. We anticipate utilizing the capacity provided by the repayments to continue to rotate into higher yielding assets. That combined with portfolio growth and the potential for increasing our investment in the JV should ultimately lead to higher income and greater coverage of our dividend. At the conclusion of the third quarter, we are cautiously optimistic of 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.
With that, I’ll turn the call over to Joyson for additional performance details, and a review of our portfolios opposition. Joyson?
Joyson Thomas
Thanks, Stuart and thank you all for joining today’s calls.
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, when compared to Q2, which was 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 than 84.8% in the prior quarter. As a reminder, a 1 rating indicates that a company has seen its risk of loss reduced relative to initial expectations, and a 2 rating indicates that company’s performing according to initial expectations.
Regarding the JV specifically, no new assets were transferred during the third quarter. However, subsequent to 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 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 resource of approximately $19.3 million at the end of Q3, including $9.4 million 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%, which was 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 as 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 as well as our resilient deal sourcing capabilities and be able 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 that was earned last year, which would have otherwise been 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 based since our IPO in December 2012, with all distributions consistent at a rate of $0.355 per share per quarter. As we said previously, we will continue to evaluate a quarterly distribution, both in the near and medium term based on the core earnings power of a portfolio, in addition to other relevant factors that may warrant consideration.
With that, I’ll turn the call over to the operator for questions. Operator?
Question-and-Answer Session
Operator
[Operator Instructions] We’ll take our first question from Bryce Rowe with B. Riley.
Bryce Rowe
Let’s see. Maybe I’ll start on the dividend. Obviously great to see dividend coverage here in the third quarter, and would kind of 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 we do, in fact, see that emerge?
Stuart Aronson
Yes. Bryce, you’ve seen for the past three years where we have excess income that would be subject to taxation. We have made the decision — 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 in fact, have earnings that would be undistributed and subject to taxation. And 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’ll be based on performance over the course of the year.
Bryce Rowe
And then maybe just a question around credit and internal risk ratings. You highlighted just essentially a stable portfolio, maybe a slight increase and what you’re seeing in three rated credits. So, can you kind of 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.
Stuart Aronson
Yes. Bryce, there is a clear slowdown in consumer demand. And there is equally clear slowdown in retailers, restocking inventory. We do believe that inventory levels got inflated during the latter half of the COVID period, where people were not confident in supply chain and so are getting as much stuff on their shelves as they could. Retailers are now looking to deplete that inventory. And 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. But we are very careful about what we’re seeing in consumer demand. We are not seeing any particular slowdown in B2B. It is at the moment a consumer led slowdown based on the evidence that we’re seeing on our portfolio. But in general, where we have seen slowdowns and where there have been covenant defaults, the owners of the company have been supportive of the company. In the case of sponsor owned companies, in every situation, the owners have been willing to support those companies as needed with cash or contingent equity.
Operator
We’ll take our next question from Erik Zwick with Hovde Group.
Erik Zwick
First question for me. From the prepared comments, I think you mentioned that you’ve had five new deals closed in 4Q and potentially 10 more in the works, no guarantee that those will close or that you’ll have capacity. And I guess my question is around kind of the second part of that comment. If you have investments that seem to be good for the portfolio, have attractive underwriting and attractive yields, how do you think about the potential to either not close those and/or take on additional borrowings to potentially fund those. I now you’re kind of getting towards the top end of your targeted arrange now, but just curious how you think about portfolio growth going forward? Maybe just in general, but also in a period of economic uncertainty like we’re in now.
Stuart Aronson
Yes. We are very skeptical of the repayment pipeline. So, we are trying to manage the portfolio so that we are not above the 1.35 times leverage. That means we have about $35 million of capacity of which we are thinking $15 million will be committed into the JV. The JV will invest in assets that are priced at less than SOFR 700, for the most part. The JV used to be focused on deals that were priced primarily SOFR 550 to 600 over the shift in the market environment, the yield on those assets is now going to be targeted more like 625 to 675.
In terms of the remaining $20 million — sorry, yes $20 million of capacity on the BDC balance sheet, we are reserving that for assets that are priced at SOFR 700 or above, and we are regularly seeing SOFR 700 on assets that are modest leverage 50% or less LTV and first lien, senior secured first lien. So, just to give you a flavor for how much the markets have moved, back about a year ago, second lien loans were yielding in the range of 650 to 750. And now we’re able to book first lien loans with returns of 700 and put them on the balance sheet. So, we are very pleased that we did not jump into that overheated market a year ago, and take on a lot of second lien assets at spreads that today would look very, very unattractive.
I’ll also mentioned that we are keeping our eyes open for good second lien investments in this market environment where people are being more conservative on EBITDA adjustments, more conservative on leverage levels more conservative on loan to value. And we think this is the type of environment for a good noncyclical company where it makes sense to book second lien loans. So, while our portfolio is currently — I think it’s 97% first lien, and our pipeline candidly is majority first lien right now, I would not be surprised over the next quarter or two if we were able to find a couple of good second lien investments in noncyclical companies that we thought presented compelling risk return for our investors.
Erik Zwick
And then, just looking at your funding profile, looks like you have some notes coming due in 2023. Could you remind me I guess what month those come due and just your thoughts are on how you would replace those?
Joyson Thomas
Eric, those notes come roll off in August of next year, $30 million of unsecured paper. The way to think about it is we’ll obviously be monitoring just the market environment. But in regards to the JPM credit facility, that facility has capacity up to $335 million and so we can comfortably replace that $30 million with the JPM facility and still be within our 1.25 to 1.35 times target profile.
Erik Zwick
And last one for me, just in terms of the unrealized losses that you recorded in the quarter. Curious if you could split that between how much was market spread related versus company specific performance?
Stuart Aronson
I don’t have that split, but just working the numbers in my head.
Erik Zwick
It was largely — I would say, Stuart, it was largely due to mark-to-market.
Stuart Aronson
Right. I would have said one-third credit related and two-thirds mark-to-market. Sounds about right, Joyson?
Joyson Thomas
Sure. I’d come back to you in terms of the breakdown between the two. Yes.
Erik Zwick
Okay. It sounds like definitely more market spread versus company specific. So, that’s helpful.
Stuart Aronson
The market spread was broad based where’s the Company-specific was only in a couple of accounts.
Erik Zwick
Makes sense. Thank you for taking my questions.
Stuart Aronson
No problem. Thank you, Erik.
Operator
[Operator Instructions] We’ll take our next question from Melissa Wedel with JP Morgan.
Melissa Wedel
I’m not sure if I missed this one. I know that you did talk about some of the activity in 4Q to date with some five new deals, and also expecting some realizations, I believe. Did you quantify that in terms of dollars?
Stuart Aronson
I don’t think we did. I don’t have those numbers handy. Joyson, do you?
Joyson Thomas
Melissa, in terms of the deals that we had originated in Q4, they related to about three new deals and then several add-ons, right? So, in terms of the total quantum, what I’d say is it probably would have been no more than somewhere between $25 million and $30 million. And then, as regards to the realizations, we had noted three exits during Q4 already, and proceeds aggregated to $30 million with respect to that.
Melissa Wedel
Okay. Thank you. I appreciate that clarification. Given your comments about the JV and seen opportunity with an additional transfer in 4Q and then potential additional investment, $15 million into that, fair to say that the growth that you’ve seen in the income from that vehicle should — that should sort of continue on that trajectory in the near-term?
Stuart Aronson
Yes, if we invest more in the JV, and the assets going into the JV have higher yields, both the existing assets and the new assets, the JV should continue to throw off returns in the low to mid-teens. And again, this market environment is extremely attractive and historically deals that were priced at 650 or 675, we were putting on the BDC balance sheet. But now based on the shift in the market, we’re able to put those higher price deals in the JV and reserve the BDC balance sheet for deals that are priced at 700 or greater. So, when you take that in combination with the rising base rates, we have a very positive trend line in the core earnings of the BDC. That could change, of course, always. But right now, the trend lines are very positive, which is not unique to us. I think the BDC community broadly is benefiting from the higher spreads and the higher base rates.
Melissa Wedel
Just one last question for me. Are you seeing any evolving sort of metrics around PIK payments, any borrowers kind of edging towards that as things get a little bit tighter? Thanks so much.
Stuart Aronson
No problem. Melissa, as we reported last year, and for several years, we’d observed in the marketplace that a lot of people were lending at leverage multiples of 6 to 8 times EBITDA off of adjusted synergized EBITDA and we thought not taking account of cash flow multiples. So, EBITDA minus CapEx, such that we saw many deals, where we believed that the operating cash flow leverage was between 10 and 14 times with LIBOR and SOFR under 1%. Those deals worked in terms of cash flows, despite the very high cash flow leverage. But with SOFR having increased 400 basis points so LIBOR as well. Our belief based on what we’ve seen, because we’ve been shown some of those deals, again, is that a lot of companies that were done at higher leverage, are now running into trouble servicing their debt on an operating cash flow basis. And we believe those companies are more likely to start having to pick some of their payments.
We did not do many or any of the deals at those high leverage levels. And as a result, we are particularly well positioned compared to others who did that to keep our deals on cash pay interest. And so, for the vast majority of our accounts, we continue to be cash pay on either — all where the vast majority of the interest payments. And again, with average leverage around four times on the deals that we’ve done, even with SOFR at 4% to 5%, or even if SOFR goes up to 6%, we believe the majority of our portfolio companies will continue to be able to pay cash interest to us and we will not have to resort to PIK.
Operator
It appears that we have no further questions at this time. I will turn the program back over to our presenters for any additional or closing remarks.
Stuart Aronson
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’d like to see. And we do make ourselves available to the analyst community to answer questions outside of this call. So again, thank you very much and we hope to share positive performance in Q4, depending on what happens over the next couple of months. Thank you much.
Operator
That concludes today’s teleconference. Thank you for your participation. You may now disconnect.
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