Horizon Technology Finance Corporation (HRZN) Q3 2020 Earnings Report, Transcript and Summary

Greetings. Welcome to the Horizon Technology Finance Third Quarter 2020 Conference Call. [Operator Instructions] Please note this conference is being recorded. I would now like to turn the conference over to Megan Bacon to begin the presentation.

Thank you, and welcome to the Horizon Technology Finance Third Quarter 2020 Conference Call. Representing the company today are Rob Pomeroy, Chairman and Chief Executive Officer; Jerry Michaud, President; and Dan Trolio, Chief Financial Officer. I would like to point out that the Q3 earnings press release and Form 10-Q are available on the company's website, at horizontechfinance.com. Before we begin our formal remarks, I need to remind everyone that during this conference call Horizon Technology Finance will make certain forward-looking statements, including statements with regard to the future performance of the company. Words such as believes, expects, anticipates, intends or similar expressions are used to identify forward-looking statements. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ on a material basis from those projected in these forward-looking statements, and some of these factors are detailed in the risk factor discussion in the company's filings with the Securities and Exchange Commission, including the company's Form 10-K for the year ended December 31, 2019. The company undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. At this time, I would like to turn the call over to Rob Pomeroy.

Good morning. Thank you for joining us and for your continued interest in Horizon. For some, I am sure it was a late night, but the world goes on and so do we. Today, I will provide an overview perspective on Horizon's performance in our current operating environment. This includes where we have benefited as well as challenges we face as we continue to navigate through the COVID-19 economic downturn. Jerry will then touch on our business development efforts and the market environment, and Dan will detail our operating performance and financial condition. And then we'll take some questions. I would like to acknowledge and commend our dedicated staff at Horizon for the way they have continued to perform during this period. We have been able to seamlessly work remotely and effectively maintain tight controls and enhanced communication between team members, borrowers, financial partners and stakeholders. It's a tribute to this team's dedication that we have been able to work so well under these circumstances. Our third quarter was solid on many fronts. We earned strong net investment income as a result of our predictive pricing strategy. We covered our distributions and maintained an industry-leading debt portfolio yield. We maintain a balance sheet appropriate for the current environment, with moderate leverage and ample liquidity to grow. We also continue to closely manage our portfolio, and though our portfolio declined in the third quarter due to higher-than-expected prepayments we remain well positioned to grow our portfolio based upon our strong and deep pipeline of quality opportunities. During the quarter, we generated net investment income of $0.34 per share, which exceeded our distributions. We achieved a debt investment portfolio yield of 15.1%. We realized proceeds and gains from the exercise and sale of warrants during the quarter, an important part of the Horizon venture lending model. We judiciously utilized our at-the-market stock offering during the quarter and raised nearly $13 million in low-cost and accretive net equity. At the end of the quarter, we had over $104 million in available liquidity and over $200 million of capacity to support our portfolio companies and to selectively make additional investments. As we enter the fourth quarter under COVID-19 and the economic downturn associated with the pandemic, we are learning more about how these conditions impact our portfolio companies. Early in the pandemic, we anticipated that certain firms could be negatively impacted by the shutdown, while others might actually thrive under the same conditions. During the third quarter, this reality manifested itself in our portfolio. On the downside, companies that were underperforming entering the pandemic have been forced to retreat. This has challenged their investors to make a difficult choice to either support these companies with an uncertain outcome or to put these companies up for sale. Those that have chosen the sale route have met with a difficult M&A market for underperforming companies. As a result, Horizon downgraded its debt investments in 3 companies at the end of the third quarter and placed them on nonaccrual in the fourth quarter. Because we are engaged in sale and liquidation efforts for these companies and their outcomes are uncertain, we have appropriately reduced the fair value of such investments as of September 30, which has negatively impacted our NAV. At the same time, 7 of our portfolio companies raised new equity, one of which also completed a successful M&A exit in the quarter, and year-to-date our portfolio companies have raised over $500 million in fresh capital. These positive portfolio events partially offset the negative NAV impact from the downgrades. As a result, we have 89% of our portfolio performing as well or better than expected at the time of underwriting and a record level of top-rated credits. We are continuing to take a measured and thoughtful approach with respect to managing our portfolio and originating new transactions. Importantly, we remain in constant communication with our portfolio companies, employing the 3-legged stool approach. That approach involves, first, engagement with our portfolio management teams to ensure they are maintaining a realistic and achievable outlook, including, where appropriate, by rightsizing their staffs and expenses to preserve liquidity. We are encouraged by the responsible way our borrowers have faced this reality. Second, seeking to ensure investors are willing and able to support portfolio companies with additional new capital now and in the future. I would note that with our portfolio companies raising over $500 million in new capital in 2020, the response from investors has been overwhelmingly positive. And third, aiding companies when they are at their most challenged through various means, including deferrals, easing covenants or making additional loans. We have done our part to support these companies in concert with management and investors. As a result of these combined efforts, over 90% of our portfolio companies have adequate cash resources to execute their business plans. Over 80% of the portfolio has cash into mid-2021, and over 50% have runway into late 2021 and beyond. Over 70% of our portfolio companies have raised capital during 2020, again showing the continued support of the investors. Entering the fourth quarter, our committed backlog and overall pipeline continue to remain active. We continue to see strong demand for venture debt within our target industries as companies simultaneously explore various paths for additional liquidity and funding. We will continue to selectively pursue new investment opportunities. With respect to distributions, we maintained our monthly distribution level at $0.10 per share through March of 2021. It is our board's policy to make distributions in amounts that can be covered by NII over time. The distribution level reflects our outlook for the remainder of 2020 and the beginning of 2021 and our spillover income at September 30. We have now covered our distributions with NII for the past 3 years. Last week, we marked our 10th anniversary as a public company. We're very proud of our team's performance and the portfolio we've collectively constructed over the years as well as the success we have shared with our shareholders. We will remain measured and proactive with respect to our portfolio as we look to opportunistically fund new investments to further expand and diversify our portfolio and ultimately generate additional long-term value for our shareholders. With that, I will turn the call over to Jerry.

Thanks, Rob. Good morning. We continue to hope you are all healthy and safe as we all traverse both the health and economic impact of the pandemic. We did begin to see some improvement in economic conditions in the third quarter, but overall, the uncertainty caused by COVID continued to be a factor. As a result, we maintained a cautious approach to our venture lending strategy, including elevating our underwriting of new investments to include a COVID-19 impact analysis. However, with knowledge-based understanding of market risk comes opportunity. Thus, we continue to selectively invest where we see significant strength. On our last call, we noted that we were beginning to see positive developments in certain technology sectors that are benefiting from the impact of COVID-19, and that trend continued into the third quarter. Utilizing our strong brand, we originated quality investments to 2 tech-oriented companies that provide software platforms. Both companies have strong management teams, committed investors, ample liquidity and have demonstrated growth even through the current uncertain economic cycle. In the quarter, we made a total of $16 million in investments to the 2 new technology companies I just mentioned as well as to existing life science portfolio companies. The onboarding yield for such investments was 11.9%. As Rob mentioned, we had strong prepayment activity in the quarter, which reflects the overall strength of our portfolio of borrowers to raise additional equity or complete M&A transactions. During the quarter, we experienced 4 loan prepayments, totaling $43 million, which significantly contributed to our NII and continued to validate our predictive pricing strategy, notwithstanding the challenging economic environment. The prepayments and accelerated income from these events helped drive a debt portfolio yield for the quarter of 15.1%. Our debt portfolio yield remains at the top of the BDC industry and once again helped us deliver income in excess of our distributions, further increasing our undistributed spillover income to $0.45 per share. During the quarter, we also received proceeds of $1.8 million from warrants in New Signature, which experienced an M&A transaction, and in Ontrak, a public company where we exercised and strategically sold out of our warrant holdings. As we've noted, structuring investments with warrants and equity rights is a key aspect of our venture debt strategy and an additional value-generate. Year-to-date in 2020, we've generated $7.9 million in proceeds from warrants, a clear indicator of our successful strategy of including warrants in the structure of our investments as well as further proof that warrants continue to be an important value-generating aspect of our overall business strategy. As of September 30, we held warrant and equity positions in 68 portfolio companies, with a fair value of $13 million. In the third quarter, we closed $36 million in new loan commitments and approvals and ended the quarter with a committed and approved backlog of $96 million, compared to $101 million at the end of the second quarter. Moving ahead, and as previously mentioned, we have approximately $96 million in our committed backlog, of which $60 million is committed to current life science portfolio companies as they meet key milestone value drivers in their development. In addition, we have added $77 million in new awarded and approved transactions to our backlog in October. Our pipeline of new opportunities as of today is $372 million. Thus, we believe we are well positioned to generate growth in the portfolio in the fourth quarter. Turning to our portfolio management activities, we continued to proactively manage our venture debt portfolio in a very challenging economic environment. Some of our debt portfolio companies have demonstrated solid growth and value enhancement, while some have been challenged. So I want to take time to discuss some of the notable specific portfolio activity that took place during the quarter. In addition to the 4 positive portfolio exits mentioned earlier, 3 credits were downgraded; one of which, Encore Dermatology, was materially impacted by COVID and was, thus, placed on nonaccrual. Another, NanoSteel, was downgraded after a failed effort to complete an M&A transaction. While Encore and NanoSteel downgrades impacted NAV in the quarter, we also ended the quarter with a record level of credits, with our highest credit rating [indiscernible]. Turning now to the venture capital environment. According to PitchBook, approximately $38 billion was invested in VC-backed companies in the third quarter, which was relatively on par with the prior year quarter despite COVID, and the number of deals remained fairly steady, with an increase in the number of late-stage companies funded. In terms of VC fundraising, $14 billion was raised in the third quarter, and the total of $57 billion raised to date in 2020 already surpasses 2019's total of $55 billion. The number of funds closed continues to be well below last year's pace, meaning that mostly large funds are able to raise funds in the current environment. In terms of VC-backed exit activity, the IPO window opened up considerably in the third quarter, with 37 venture-backed IPOs contributing to a total exit value of $104 billion, the second highest total on record. With the IPO window still open, we are seeing other firms looking at IPOs as another path to generate additional liquidity. Turning now to our core markets. We remain focused on the technology, life science and healthcare technology markets, where we continue to selectively seek investment opportunities. During the quarter, we provided funding to 2 new portfolio companies: a $10 million venture loan to Topia, a developer of global talent mobility software, and a $5 million venture loan to BriteCore, a developer of cloud-native software for property and casualty insurance. We also funded an additional $1 million to 2 of our existing portfolio companies. We enter the last quarter of 2020 with a strong balance sheet, characterized by ample liquidity and lower leverage, and a strong pipeline of new investment opportunities. We believe this positions us well to navigate through the current environment while selectively growing our portfolio and delivering additional long-term shareholder value. With that, I will now turn the call over to Dan.

Thanks, Jerry, and good morning, everyone. I will provide a quick review of our third quarter 2020 results before opening up for questions. As mentioned on our last call, we successfully strengthened our balance sheet during the year, which provides us increased liquidity and lending capacity. In part, these efforts led to a strong liquidity position at the end of the quarter. On balance sheet, as of September 30, Horizon had $104 million in available liquidity, consisting of $57 million in cash and $47 million in funds available to be drawn under our existing credit facilities. As of September 30, there was $15 million outstanding under our $125 million KeyBank credit facility and $13 million outstanding on our $100 million New York Life credit facility, leaving us with ample capacity to grow the portfolio. Additionally, during the third quarter we issued 1.1 million shares under our ATM program, receiving $13 million in net proceeds. Our debt-to-equity ratio stood at 0.81:1 as of September 30, which was lower than our targeted leverage of 1.2:1. Based on our cash position and our borrowing capacity on our revolving credit facilities, our potential capacity is $254 million at September 30. For the third quarter, Horizon earned total investment income of $12.3 million, an 8% increase compared to $11.4 million in the prior year period. This increase was primarily due to a 21% increase in interest income on investments given the larger average size of our loan portfolio. Our debt investment portfolio on a net cost basis stood at $319 million as of September 30, a 10% reduction from June 30, 2020. For the third quarter of 2020, we achieved onboarding yields of 11.9%, compared to 11.1% achieved in the second quarter. Our loan portfolio yield was 15.1% for the third quarter, versus 17.7% for last year's third quarter. Turning to our expenses, for the third quarter total net expenses were $6.5 million, compared to $5.6 million in the third quarter of '19. Our interest expense was up $561,000 compared to the prior year period, primarily due to an increase in the average borrowings, partially offset by a reduction in our effective cost of debt. Our base management fee rose $222,000, driven by an increase in the average size of our portfolio. Net investment income for the third quarter was $0.34 per share, compared to $0.40 per share in the second quarter of 2020 and $0.42 per share for the third quarter of '19. As Rob mentioned, we have now covered our distributions with NII for the past 3 years. The company's undistributed spillover income as of September 30 was $0.45, an increase from $0.42 as of June 30. To summarize our portfolio activities for the third quarter, new originations totaled $16 million, which were offset by $6 million in principal payments and $43 million in principal prepayments. We ended the quarter with an investment portfolio of $312 million. The portfolio consisted of debt investments in 34 companies, with an aggregate fair value of just under $299 million, and a portfolio of warrant, equity and other investments in 69 companies, with an aggregate fair value of $13 million. Based upon our outlook for NII, our liquidity forecast and our spillover income levels, our board declared monthly distributions of $0.10 per share for January, February and March 2021. We have now declared monthly distributions of $0.10 per share for 51 consecutive months. We remain committed to providing our shareholders with distributions that are covered by our net investment income over time. Our NAV as of September 30 was $11.17 per share, compared to $11.64 as of June 30, 2020, and $11.67 as of September 30, 2019. The $0.47 reduction in NAV on a quarterly basis was primarily due to our distributions and a net unrealized loss on investments exceeding our net investment income and net realized gains. As we've consistently noted, 100% of the outstanding principal amount of our debt investments bear interest at floating rates, with coupons that are structured to increase as interest rates rise, with interest rate floors. As of September 30, 100% of our portfolio is at their specific floors. This concludes our opening remarks. We'll be happy to take questions you may have at this time.

[Operator Instructions] Our first question is from Mike Smyth, with B. Riley Securities. Mike Smyth;B. Riley;Analyst: So I guess my first question is, early payoffs really outpaced originations in the quarter. And you mentioned your pipeline currently sits around $372 million and expectation for growth in the fourth quarter. So I was wondering if you could just talk a little bit about your expectation for repayments and how that kind of relates to your expectations for portfolio growth in the fourth quarter.

Mike, this is Jerry. We were actually pleasantly surprised by the exits we had in the quarter. Actually, 3 out of those 4, 2 of them we were paid out through equity raises the companies did at significantly higher valuations; so at basically cheaper equity. So that allowed them to repay our debt. And we hold warrants in one of those companies. Actually, we've got warrants in both of those companies. So those were positive. And then New Signature, they completed a previously announced M&A transaction. So that was also a very positive event. So those were great. The equity ones were a little unexpected. We weren't really expecting to be paid off, but it was probably prudent for those companies to lower their leverage. And so that was fine. As we look forward -- so we funded $16 million in the quarter. I would say that that was fine by us. We definitely have slowed our underwriting process and added to that process. So that's taking a little bit longer to get transactions through prescreens and then through underwriting. And so I think previous 9 quarters we've grown the portfolio. So we weren't too concerned about the fact that the portfolio didn't grow in the third quarter. But there were a lot of transactions in the pipeline, and that is the good news. As I mentioned, I think we have about $77 million in just new awards and approved transactions just in October. So our expectation for the fourth quarter looks very positive relative to growth. We expect to see growth in the fourth quarter. As it relates to prepayments, going forward, right now I would say that we don't expect to have prepayments at the level that we had in the third quarter, as I sit here today. But obviously, those tend to come up later in the quarter. So we'll see what happens. But I am fairly confident that the portfolio will grow in the fourth quarter. Mike Smyth;B. Riley;Analyst: That's helpful color. And then how are yields, covenants, kind of et cetera looking on some of the new investments you're looking at? Has the COVID premium spread kind of disappeared? Any color you could provide on the marketplace would be helpful.

In terms of pricing, not really; not much change. Everything has been pretty consistent through the whole COVID-19 thing. And I'm not just speaking for Horizon, but we obviously look at the competitive marketplace. And we continue to be competitive, and pricing has held up pretty well. I think that as we look at a transaction, as I mentioned earlier, we do actually have kind of a COVID analysis that we do now on every transaction, not only for looking at the new prospect company but also the markets that they serve. And so as it relates to things like covenants, I would say our covenant position is a little stronger than it has historically had to be, given the uncertainty really of COVID-19. We don't feel like we're -- that that storm is over yet. We feel like we're still in it. We need to be cautious because of it. And so most of the transactions, we are moving forward with do require a little bit higher level of covenant protection. Mike Smyth;B. Riley;Analyst: That's helpful. And so another question would be leverage came down a bit. Can you just talk about kind of how you think about that in the near term, given your expectations for origination and repayment activity?

Mike, this is Dan. I appreciate that. As you mentioned, the prepayments exceeded our originations for this quarter. And with the ample cash, we paid down the facilities to maximize costs. And so looking forward, our target leverage is still within the 0.8:1 to 1.2:1. We have ample capacity and liquidity. And so we will tap the facilities when we need to fund our pipeline. So our target is still within the [ 1.8 ] to 1.2. Mike Smyth;B. Riley;Analyst: Got you. That's helpful. And just one more for me. And forgive me if I missed this, but 3 companies were downgraded to "1" ratings. I think you mentioned NanoSteel and Encore. I was just wondering if you could provide some more color on the third one.

The third one was Titan Pharmaceuticals. Mike Smyth;B. Riley;Analyst: And is there any specific color you could provide with regards to Titan?

Yes. So actually, Titan was a deal that we had on our books. I think we owed about $1.9 million, at cost. We have actually settled that account, it's right in the process, all but signed and delivered, at the fair value we carried it at September 30. One of our other nonaccrual notes we've also settled ?- we're right in the process of settling right now. So we've marked all of the marks where we have agreements to settle these on most of these, and we expect them to take place in the fourth quarter.

[Operator Instructions] Our next question is from Bryce Rowe, with National Securities.

Dan, I wanted to ask you about the availability based on the borrowing base with that New York Life facility. Just saw in the Q that availability was just $2.2 million. So kind of curious why it's kind of that low relative to a $100 million line. And what was it at the end of June, just for comparative purposes?

So if you recall, the New York Life facility is a new facility we put in place in the second quarter. And so it started off with close to $30 million of assets in that specific facility. Availability was north of that. So we have maybe about $10 million, $15-ish million available. One of the factors relating to the reason the availability came down this quarter is that a number of the prepayments that happened in the quarter were specifically in that facility. So the pool of assets in there came down, and the fundings and the movement of assets going in were later in the quarter, just didn't get completed until after the quarter. And so that's the reason why the availability is down from June. But the facility is in a good position. And as we add new originations, it will add to the pool and that availability will come up.

Okay. That's helpful. And Rob, I just wanted to clarify, I guess, the answer to the last question that was just asked about the 1-rated credits and them being under contract. So there's some expectation here in the fourth quarter that they'll get resolved and moved out? Or do you expect them to come back on to accrual status with whatever resolution you've got in place?

So as I said in the introductory comments, we're actually in a sale liquidation process on these accounts, and we expect them to settle for cash and not return to accrual status. So we'll have cash to redeploy in new assets.

Our next question is from Ryan Lynch, with KBW. Ryan Lynch;KBW;Analyst: I just had a couple of ones. Just wanted to make sure I heard this correctly. Did you say in your prepared comments that NanoSteel, that was one of the investments that was marked down but is still on accrual status? Did you say that that was placed on nonaccrual status in the fourth quarter? And you said that that was marked down due to the company failing to complete M&A transaction? Is that a process you guys are still pursuing with that company, a different sort of M&A? Or what's the kind of outlook on that?

Thanks, Ryan. That's a good point. NanoSteel was one of the accounts that got downgraded to a 1, but was current through the end of the quarter. And it was information that came after the quarter that required us to downgrade it. And so it was on accrual as of September 30, but in the fourth quarter it is on nonaccrual as we continue to work through the process of settling that account. Ryan Lynch;KBW;Analyst: Okay. And another one I had on a current nonaccrual, IgnitionOne, I know you said you guys are in the process of potentially exiting some nonaccruals. That one has been on nonaccrual for a while. That's still marked at 100% of you guys' cost. Can you just remind me of why that investment is marked so high relative to some of your other nonaccruals?

Ryan, this is Rob. Just to refresh your memory, IgnitionOne was a company that had some difficulties, but they ended up selling parts of the company to another private company. And in that process, we were -- the secured creditors were paid down, and we are the only remaining secured creditor against the estate of IgnitionOne, which holds a substantial amount of private stock in the acquiring company of IgnitionOne which secures our loan. The value of that stock is multiples of our debt. Unfortunately, it's also illiquid. And so we're waiting for an opportunity to either transact that stock in a secondary sale or for that company to effect a transaction that would make that stock more liquid. So we do believe that our balance is secure. So we've rated that credit, although it's on nonaccrual because we're not getting paid anything, we continue to rate that as a 2-rated credit. Ryan Lynch;KBW;Analyst: Got you. Makes sense. And then just finally I had one more. Can you just talk about the ATM equity capital raise this quarter? You guys had very strong prepayments in the third quarter that well outpaced you guys' originations. So you guys had net repayments in the portfolio in the third quarter. So can you just talk about why you guys chose to raise additional equity capital [indiscernible] came on top of that and actually further push you guys' leverage down this quarter?

It's a good question, and parts of the answer have been given already, but I'll put it all together for you. One, the ATM has been in place and operating. And so when the stock trades well, we take advantage of the opportunity to issue stock that's accretive to our existing shareholders. So we were raising that money during the quarter. We were a little bit, as Jerry said, a little bit surprised by the companies that raised the equity at very high valuations that they actually were going to repay us. We thought there was a chance that we would either roll new loans or extend terms on our existing loans. So that took us a little bit by surprise. Having said that, we have a very strong pipeline. We expect to grow the portfolio, and we're trying to take advantage when we can of raising additional equity as well to support the good debt facilities that we've obtained as well.

Thank you. With no further questions, I would like to turn the call back over to Robert Pomeroy, Chairman and CEO, for closing statements.

So thank you all for joining us this morning. We appreciate your continued interest and support in Horizon. We hope you and your families continue to remain safe and healthy, and we look forward to speaking with you again soon. This will end the call.

Thank you. You may disconnect your lines at this time, and thank you for your participation.