WhiteHorse Finance, Inc. (WHF) Q3 2017 Earnings Report, Transcript and Summary

Good morning. My name is Stephanie, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Third Quarter 2017 Earnings Conference Call. Our host for today's call are Stuart Aronson, Chief Executive Officer; and Ed Giordano, Chief Financial Officer. Today's call is being recorded and will be available for a replay beginning at 2 p.m. Eastern. The replay dial-in number is 404-537-3406 and the PIN number is 4498809. [Operator Instructions] It is now my pleasure to turn the floor over to Sean Silva of Prosek Partners.

Thank you, Stephanie, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's Third Quarter 2017 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. During this call, we'll discuss GAAP and non-GAAP financial measures, for which a reconciliation can be found in our press release, which is available on our website, www.whitehorsefinance.com. With that, allow me to introduce WhiteHorse Finance's CEO, Stuart Aronson. Stuart, you may begin.

Thank you, Sean. Good morning, and thank you for joining us today. As you're aware, we issued our press release this morning prior to market open, and I hope you've had a chance to review our results, which are also available on our website. I'm going to take you through our third quarter operating performance, and then Ed will review our financial results, and after that, we're happy to take questions. Our third quarter results were impacted by 2 mandated deals, which did not close, resulting us not deploying BDC funds, as planned. In the case of 1 of these deals, we determined the credit risk was too high to close it. The key takeaway is that we will not agree to terms that are inconsistent with our core investment philosophies. We have a prescribed set of principles that we will not diverge from for potential short-term gain to the long-term detriment of our portfolio. The capital we would've allocated to these deals remained under -- undeployed during the third quarter and when combined with lower-than-normal amendment and waiver fees that we received during the quarter, we recorded net interest income of $0.29 per share, falling below our dividend of $0.355. While we anticipate fourth quarter net interest income will also be impacted by less-than-targeted assets outstanding, we expect this trend to reverse once we're fully redeployed. As our investors are aware, we've had a long run of covering our dividend, both on a quarterly basis and for the full year. Our bias will always skew towards conservative and appropriate credit decision making, given that we still delivered strong results across our platform for the quarter and the momentum we've built over the past few quarters, we are optimistic about our ability to move forward and continue delivering to our partners and our shareholders. Turning now to the rest of the third quarter results. I'm pleased to share that NAV per share for the quarter increased up to 39 -- $13.92, up from $13.83 last quarter, and our weighted average yield remained very strong at 11.9%. We had 1 new origination during the quarter with a hold position that fell into our normal target range of $4 million to $20 million. This was an $8.5 million loan to Montrose Environmental Group, which is an environmental solutions provider. While this was a second lien secured term loan, we continue to increase diversity in our BDC and maximize, to the extent possible, first lien assets over second lien assets. We also recorded total repayments and sales for the quarter of $14.8 million, which was meaningfully better than the $35.5 million recorded during Q2. This quarter's activity was primarily driven by a full paydown of $7.2 million on the Fox Rent A Car, as we exited the car rental sector, and a partial paydown of $ 2.3 million on Pay-O-Matic Corp. Turning now to our investment portfolio. As of September 30, 2017, the fair value of the portfolio was $435.3 million, which is below the $437.9 million reported at the end of the second quarter. As of that same date, our loan portfolio consisted primarily of senior secured loans to lower mid-market borrowers, which were variable-rate investments. The portfolio had an average investment size of $11.5 million based on fair value, with the largest investment being $26 million. Within the portfolio, we held 38 positions across 31 different companies. During the quarter, we also saw a net mark-to-market gains in our portfolio of $3 million, led by markups of roughly $3.6 million in fair value for our positions in Aretec Intersection and the first lien tranche of Grupo HIMA. This speaks to the continued strengthening of our portfolio and for Aretec, we continue to see performance improved, as we also marked up this position last quarter. For Grupo HIMA, we view the increased government focus on needs of Puerto Rico to be a positive for that credit. Looking ahead into Q4, we are already seeing better volume for mandated deals during the quarter and are in active due diligence and documentation on several of these transactions. However, there is always uncertainty regarding which mandated deals will successfully be closed based on the due diligence results. I'll turn now to the macro outlook. We continue to see many firms actively pursuing deals in the main portion of the sponsor mid-market and lower market. Conversely, we remain focused on smaller and less-covered sponsors, where we are finding good risk return. Our observation is that pricing in the sponsor market is between 50 to 100 basis points lower than it was a year ago. In the nonsponsored market, we are avoiding processes that are being managed by large investment banks, poor shopping opportunities widely. Generally, because of today's aggressive market conditions, we've been increasingly more selective from a credit perspective. Now to offset this increased selectivity, we've increased our origination staffing, adding 2 resources in San Francisco and a resource in Washington, D.C. As a result of our expanded origination efforts across the business, our deal pipeline is 50% to 100% larger in any given week than what we were experiencing a year ago, and we'll keep you informed on how that develops. With that, I will now turn the call over to Ed. Ed, go ahead.

Thanks, Stuart. Starting with our third quarter results from operations. NII was $5.9 million for the quarter or $0.29 per share. This compares to $6.9 million or $0.378 per share in the prior quarter. Our investment income continues to consist primarily of recurring cash interest. We reported a net increase in net assets resulting from operations of approximately $9.1 million or $0.45 per share for the third quarter. As of September 30, 2017, net asset value was $285.5 million or $13.92 per share, up from $283.8 million or $13.83 per share, as reported for Q2. And as it pertains to our portfolio and investment activity, the risk ratings for -- on our portfolio remain mostly unchanged. Turning to our balance sheet. We had cash resources of approximately $41.9 million as of September 30, 2017, including $4.8 million of restricted cash and approximately $45 million of undrawn capacity under our revolving credit facility. We continue to closely monitor our asset coverage ratio and feel comfortable with our leverage as of September 30, 2017. The company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 244 -- sorry, 254.4% at the end of the third quarter, well above the statutory requirement of 200%. Our net effective debt to equity ratio after adjusting for cash on hand was 0.50x. Last, I'd like to highlight our quarterly distribution. On September 6, we declared a distribution, for quarter ended September 30, 2017, of $0.355 per share for a total distribution of $7.3 million to stockholders of record as of September 18, 2017. The distribution was paid to stockholders on October 3. This marks the company's 20th distribution since our IPO in December 2012, with all distributions at a rate of $0.355 per share per quarter. We expect to be in a position to continue our regular distributions. I now turn the call to the operator for your questions. Operator?

[Operator Instructions] Your first question comes from Rick Shane with JPMorgan.

We appreciate the specific commentary about passing on that transaction. I am curious, how to think about this, which is that -- are you seeing specific new competitors for additional competition for the assets that you're seeking? Or is it broader, sort of, pushdown from larger leverage loan markets, and some of the more trafficked broker deals impacting pricing in your specific niche?

If I don't answer your question fully, please redirect me, but I would tell you that we are seeing that processes that get intermediated by bankers are resulting in new entrants who don't have origination capacity, but who rely on the banks for volume, coming in and doing things either on a credit perspective or on a pricing perspective that we won't do. Without any names, I can give you an example. There was 1 deal this quarter that we were interested in, but 1 of our competitors took the banker's book and committed to the deal, waiving due diligence without having done their own direct due diligence on the deal. That violates our credit standards and notwithstanding that we found the deal directionally interesting based on what the banker told us, we will never commit -- we would never plan to commit, I can't imagine how we'd ever would, to a deal without doing our own organic due diligence. So there are situations who are arising, where, because our intermediaries are sending these opportunities out to a broad array of players, outliers are showing up that are doing things that we think are improper from a credit perspective or improper from a pricing perspective. That's why we've redoubled our efforts on our direct origination model, leveraging the H.I.G lower mid-market, feed-on-the-street mechanism for finding deals, where there is limited competition. And I would tell you of the mandated deals we have here in Q4, I don't believe any of them were intermediated by a major investment bank. So we are finding deals the old-fashioned way, and it is not a great moment in time to go up against 20, 30 or 40 other players to buy a loan in an auction. Does that answer your question fully?

It absolutely did. I mean, look, I do think that H.I.G gives you a differentiated origination strategy and part of what I was curious about related to the transaction you alluded to, was whether or not it was in H.I.G.-type deal that the terms just were untenable or it was actually a deal that was done away from you. And it sounds like it was the latter.

It was actually neither. There was a -- the due diligence that we did and the situation resulted in a shift of the credit risk that we could have accepted and closed on the deal and gotten even more price, but we didn't deem the risk return to be the right answer. We deemed it to be an unacceptable risk, and we walked away.

Understood. Look, everybody on this terms is an investor, and one of the things that's always regrettable is when you knowingly break discipline and then have a mistake. And so it's one of the things where it causes everybody to try to prevent themselves from breaking discipline, and that sounds like the way you guys approached this.

It is. And I will tell you, philosophically, both speaking for myself and speaking for the investment committee that approves these deals, and we have 9 individuals on the investment committee that have to unanimously agree, the focus is on the old adage in lending that you only make money if you don't lose money. And so we subject all of the transactions that we do to severe downside cases that typically are a repeat of The Great Recession. And if we can't determine that we will get back all our money to a repeat of that, then those are deals, we walk away from.

[Operator Instructions] Your next question is from Bryce Rowe with Baird.

Stuart, I wanted to ask about the pipeline and certainly, the redoubling of -- on origination efforts, and I appreciate the commentary there. And based on conversations that we've had and some of your comments on past calls, I understand that it takes a little bit longer and a little bit more effort to find this "nonsponsored deal. So just curious, if you can handicap for us, what type of deployment goals you might have for -- maybe, for the next few quarters. And try -- again, try to handicap that against the current market conditions that you just spoke to.

Bryce, it's a complicated question. Let me try to answer it as directly as I can. I'm pleased to share that at the moment, we have 7 mandates. I'll also caution you again that just because we have a mandate doesn't mean -- especially in the nonsponsor world, doesn't mean that when you do diligence that mandate, that it's a deal you'll close. But that is a nice group of mandated deals, and we always hope as many of those as possible will close. And if we get a majority of those to close, even before any more mandates that we're working on, that will allow us to have a significantly more deployment in the quarter than we had in Q3. Right now, if we were going to target 78% leverage, we have $80 million of capital to deploy, I want to deploy, if I can, the majority of that in Q4 and then the rest of it in Q1. The other thing, I guess, I'd share is, sort of, a follow-up question you could ask, but I'll get ahead of it. If we deployed that $80 million at a net return of 8.5% to 9.5% after leverage cost, which is very reasonable, given our historical deals, we've closed, that would be worth $0.08 to $0.09 per share per quarter, based on the math our team did. So while we did not earn our dividend this quarter, the cash and levers that we have available to us, once deployed, would imply that we should be able to earn our dividend on an annual basis. And hopefully, on a quarterly basis as much as possible. Does that answer your question, Bryce?

And I certainly appreciate the -- don't get me wrong, I appreciate the focus on capital preservation, NAV per share preservation over and above dividend coverage at this point. I'd wanted to also ask about the amendment in waiver fees being down this quarter. Was there something abnormally -- or abnormal about the quarter in terms of some of that fee recognition, or would you expect this level of amendment and waiver fees, going forward?

So we have a bit of a catch-22, which is waiver and an amendment fees are typically accompanied by both covenant violations and prepayments. And so when we have a really good quarter for the portfolio, where the portfolio performs well and things don't pay off, that's when amendment and waiver fees come in lower. So it's -- the good news drives what, I guess, is the bad news on the earnings. Normally, in the nonsponsor business where covenants are set quite tightly, there are covenant violations in a quarter. And the majority of our business continues to be nonsponsor business with tight covenants. So in a more normal quarter, there will be more covenant violations, and those covenant violations will generate fees. The other thing we get, especially on our nonsponsor business, is prepayment penalties that stretch out 3 and even 4 years. And in a normal quarter, we generally have more prepayments, and there are prepayment fees that come to us with that. So it was because Q3 was such a strong quarter for the portfolio, that the amendment and waiver fees and prepayment fees were very low. It's hard to project, other than to say, if you look at all the preceding quarters, we normally don't have so few violations or so few repayments in a quarter. So just based on history, it's reasonable to expect that those numbers will generally be better in future quarters. I can't promise that, but it - just based on history, that's the more normal situation.

And Bryce, I'd add to the tale of that, that this is significantly lower than our historical quarterly average fees.

Thank you. That does conclude today's conference call. You may now disconnect.