WhiteHorse Finance, Inc. (WHF) Q3 2018 Earnings Report, Transcript and Summary

Good morning. My name is Lori, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Third Quarter 2018 Earnings Conference Call. Our hosts for today’s call are Stuart Aronson, Chief Executive Officer; and Ed Giordano, Interim Chief Financial Officer. Today’s call is being recorded and will be available for replay beginning at 1:00 p.m. Eastern. The replay dial-in number is (404) 537-3406 and the PIN number is 9978567. At this time all participants have been placed in a listen only mode and the floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Sean Silva of Prosek Partners.

Thank you, Lori, and thank you, everyone, for joining us today to discuss WhiteHorse Finance’s Third Quarter 2018 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. With that, allow me to introduce WhiteHorse Finance’s Chief Executive Officer, 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, after which we’re happy to take your questions. During the third quarter, we continued our strong momentum, and I have a series of very positive items to share with you this morning. First, we increased NAV per share to $15.46, a 59% improvement from the second quarter of 2018 and an increase of $1.54 from the third quarter of 2017. Core net interest income was $0.349 per share, slightly below our quarterly dividend of $0.355, which we continue to expect to earn on an annualized basis. Core net interest income includes -- excludes 2 items that I will briefly summarize and which Ed will detail. First, the sale of Aretec closed the day after the quarter ended. Given the high degree of visibility into closing of the transaction, we marked the asset at the end of the third quarter for the full value of the expected proceeds. In connection with this markup, we recognized an additional capital gains-based incentive fee accrual of approximately $3.1 million that is deducted from GAAP income. Second, during the quarter, we incurred a onetime noncash net refinancing cost associated with the redemption of our 6.5% baby bonds back in August. Ed will provide further detail on core versus GAAP net interest income. But first, I’ll detail key highlights from our quarter, which in addition to our strong performance, was marked by 4 significant developments. First, as I’ve mentioned, at the end of the third quarter, we marked our position in Aretec up to the expected value of the gain, increasing our position to $53.8 million from $37.4 million and driving a mark-to-market gain of just under $16.5 million. We will manage the gain on Aretec in a manner that we believe is optimal for shareholders by retaining a majority of those gains as investable capital for our portfolio, while monitoring the tax implications of retaining this capital and potentially paying out a special dividend to shareholders in the future. Second, because the proceeds of Aretec sale have meaningfully elevated our cash levels, our advisor, H.I.G. WhiteHorse Advisers, has agreed to waive management fees on cash for the third and fourth quarters of 2018 as well as for the first quarter of 2019 so as to not disadvantage our shareholders while proceeds are reinvested. Third, in addition to our temporary pass fee waiver, we’ve also adjusted our management fee structure. At an in-person board meeting last week, our Board of Directors voted to reduce fees by 75 basis points on assess -- assets in excess of one times leverage from 2% down to 1.25%. If the BDC operates at 1.25% leverage, the benefit of this fee reduction will be close to $0.03 per share per year to shareholders. Fourth, in an effort to enhance our ability to invest in lower-risk senior secured assets, we have submitted a request to the SEC in conjunction with the State Teachers Retirement System of Ohio, or STRS Ohio, to establish a joint venture providing up to $125 million of capital on a combined basis with $75 million to be provided by WhiteHorse Finance. If approved, the JV will invest indirectly originated senior secured assets priced primarily between LIBOR 500 to LIBOR 650 that are sourced by our existing sponsor and nonsponsor originations infrastructure. This JV would operate with 1.5x or greater leverage in those senior secured -- on those senior secured assets with the goal of returning mid-teens returns to the capital invested by WhiteHorse Finance. We believe this joint venture will increase diversification and deal flow, while maintaining the risk-adjusted return characteristics of the overall portfolio as sourcing and underwriting standards will remain unchanged. I will caveat, however, that the JV has not yet been approved by the Securities and Exchange Commission and there can be no assurance that they will approve. Management also continues to act till we review the liability side of the balance sheet. We are currently in discussions with JPMorgan to implement an amendment to our credit facility that would support increased leverage in exchange for decreased concentration of second-lien loans. Turning now to our investment portfolio. As of September 30, 2018, the fair value of the portfolio was $509.6 million compared to $511.4 million reported at the end of the second quarter and consists primarily of senior secured loans to lower mid-market borrowers that are variable-rate investments, primarily indexed to LIBOR. During the quarter, we generated one new origination for $7.4 million and added a $11 million position on a secondary basis. We also funded two add-ons during the quarter, totaling approximately $10.5 million. We also participated in a refinancing for our existing portfolio company, Golden Pear, which was acquired by a private equity firm. We reinvested $17.2 million of the $25 million of refinancing proceeds in the new transaction. Repayments in sales, excluding this refinancing were $38.9 million, driven by a full pay down on Intermedia Holdings of $18 million, a full pay down on Sitel of $8.7 million and a partial repayment of our position in Crews of California of $7.7 million. The portfolio had an average investment size of $10.4 billion based on fair value, while we did have three portfolio companies above the upper range of our target investment size of 20 million, including Aretec, CA and FPT, we remain focused on reducing our exposure on those positions and expect to have reduced two of the three of those by year-end. Our leverage ratio decreased during the third quarter to 62%, falling below our historical target range of 70% to 80% and below the 71% recorded at the end of the second quarter. As shared last quarter, we do intend to carefully ramp up investments and manage WhiteHorse Finance at a leverage of 1 to 1.25 times in the future. Turning now to our Q4 pipeline. Thus far, in the fourth quarter, we have closed two transactions with an additional six transactions that are mandated, seven of those eight transactions are first lien and four of them are nonsponsor. As always, there can be no assurance that any mandated transaction will close as there remains much due diligence to be done on many of those situations. I’d like to take a moment to put our pipeline in our portfolio in historical context as I think it provides strong perspective on what we’ve been able to accomplish. As you’ve heard in our earnings calls, we’ve taken a prudent and disciplined approach to sourcing an origination. We reviewed thousands of deals every year and turned down over 98% of those. We walk away from any conversation when we’re asked to inappropriately lower and are losing our standards. And as a result, our historical conversion ratio and deal flow is under 2%. And we continue to prioritize quality over yield and long-term shareholder value over short-term gains. To that end, 12 months ago, 57% of our credit portfolio was comprised of first-lien secured loans, which was consistent with our historical average. While competitive on a relative basis, we wanted to do better and set a goal to meaningfully improve upon this metric. As of September 30, 2018, our portfolio is now comprised of 74.5% first-lien senior secured loans. During that same period, we’ve increased NAV from $13.92 to $15.46, added 11 new positions on a net basis to our portfolio, minimized our loan exposure to loans that were on nonaccrual, and we reached a very positive resolution on Aretec, all while preserving a weighted average effective yield of approximately 12%. Throughout that time, roughly two thirds of our portfolio has been nonsponsor, illustrating our strong direct origination infrastructure backed by the three tiered sourcing architecture at H.I.G. With that context, and when also considering the various initiatives undertaken this quarter that I referenced earlier in my remarks, we are clearly optimistic about the future of WhiteHorse Finance. That optimism is also fueled in part by our long-term outlook on the composition of our shareholder base. As is publicly known, 51% of the total shares of WhiteHorse Finance are currently owned by the Bayside funds, which are affiliated with H.I.G. It is reasonable to assume that these H.I.G. funds as they reach their latter stages of their life will reduce their exposure and ensures the WhiteHorse Finance in a way that maximizes value and minimizes disruption to the trading of shares of the company. This is evidenced by H.I.G.’s recent $13.5 million block trade sale executed in August. To be clear, we anticipate that any future sales of shares will be managed in an orderly process over several years, understanding that the timing of sales will be determined by many factors beyond our control. We will continue to be as communicative as possible about these ongoing developments as our shareholder base become more worse diversified and liquid over time. And with that, I’ll now turn the call over to Ed.

Thanks, Stuart. I’ll first address the nonrecurring items for the third quarter and then expand to the rest of the third quarter results. As Stuart mentioned the sale of Aretec close in the fourth quarter, however, because we had clarity that the transaction was closing, we marked the asset at the end of the third quarter to the full value of the gain. This resulted in a $3.1 million accrual in the form of a capital gains incentive fee. To summarize, we marked the asset up at the end of the third quarter and we received the actual cash during the fourth quarter. During the quarter, we also incurred the net impact of accelerated amortization of deferred debt issuance costs associated with the refinancing of our baby bonds, which totaled approximately $300,000. As such, we reported GAAP net investment income of $3.8 million or $0.184 per share. This compares to $4.6 million or $0.224 per share in the prior quarter. Core NII, which excludes the non-recurring items I just mentioned, was $7.2 million for the quarter or $0.349 per share. This compares to $6.8 million or $0.331 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 $19.5 million or $0.95 per share for the third quarter, which includes a $16.5 million markup of Aretec. As of September 30, 2018, the net asset value was $317.7 million or $15.46 per share, up from $305.3 million or $14.87 per share as recorded -- as reported for Q2. As it pertains to our portfolio and investment activity, the risk ratings of our portfolios saw modest improvements with 3 of our positions being upgraded to a 2 or a 1 rating. Turning to our balance sheet, we had cash resources of approximately $26.6 million as of September 30, 2018, including $15.1 million of restricted cash and approximately $31.5 million of undrawn capacity under our revolving credit facility. Pro forma for the sales proceeds from Aretec sale and a pay down of our revolving credit facility to the minimum required levels, our cash resources would be approximately $66.9 million. We continue to closely monitor our asset coverage ratio and feel comfortable with our leverage as of September 30, 2018. The company’s asset coverage ratio for borrowed amounts as defined by the 1940 Act was 260% at the end of the third quarter, well above our newly reduced requirement under the statute of 150%. The net effect of debt to equity ratio after adjusting for cash on hand was 0.54x as of the end of the quarter. Next, I’d like to highlight our quarterly distribution. On September 7, we declared a distribution for the quarter ended September 30, 2018, of $0.355 per share for a total distribution of $7.3 million to stockholders of record as of September 18, 2018. The distribution was paid to stockholders on October 3. This marks the company’s 24th 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’ll now turn the call over to the operator for your questions. Operator?

[Operator Instructions] Your first question comes from the line of Tim Hayes of B. Riley FBR.

My first question, have you begun redeploying the proceeds from Aretec yet? And then does the fee waiver announcement imply that you expect all the Aretec proceeds to be redeployed by the second quarter of 2019?

So Q4 is normally a strong quarter for asset deployment in the marketplace. The fact that we have a large number of mandated deals will give us an opportunity to deploy some of the cash that has been generated by the Aretec sale. And it is our desire that all of that cash or the majority of that cash would be invested before the already announced fee waiver on cash is expiring. That said, we will continue to monitor the cash situation, and if it was deemed appropriate, that fee waiver could be extended, if needed, again, subject to approvals at the time.

And then you’d mention that you’re currently evaluating or will be evaluating whether to pay a portion of the gain from Aretec as a onetime dividend. Just wondering, when you expect the timing around a decision or an announcement would be made?

So we have the ability to roll forward much of that gain with the payment of only a 4% excise tax on an annual basis. We view that ability to roll forward gain as very accretive to shareholders in terms of creating investable capital to the extent that there is a portion of the gain that is not qualified for that 4% excise tax roll forward that would otherwise be subject to full taxation, we would consider doing a special distribution or special dividend of those amounts as opposed to paying the full tax charge. It is not expected that, that will happen in the near future as the performance of the company over the ensuing quarters will dictate what portion of that gain can be rolled forward. So we’ll provide more data on that as more data is available. But it would not be -- we do not expect that it would be in the next few quarters.

And then, Stuart, as you mentioned, your regulatory leverage ratio is well below your target range. How do you intend to increase leverage over time? I know you mentioned kind of the discussions you’re having with -- on the JPMorgan facility. And how long do you think it’ll take you to get to that target range, especially with all the proceeds of Aretec coming back for you to invest?

Yes. We have a very large amount of money for the BDC to invest. And Tim, the most important thing is that we invest prudently. I would rather be underinvested and I would rather sit on cash than put the money into investments that I believe would suffer during a downturn. We don’t know when a downturn is coming, but we want to be prepared and prudent. That said, we have a very strong originations team. The BDC benefits from a very significant architecture, which includes 34 investment professionals in the WhiteHorse Direct Lending organization and that is actually going to increase. We’re hiring more people as we speak, and that gives us the ability to drive deployment in a responsible manner. It is my expectation that getting to full deployment will take probably about a year, but if it could happen sooner, that would be great. And if it takes longer, then we will ask our shareholders to be patient with us. But we have a solid pipeline, and we do intend to grow to the full size of the BDC as quickly as possible. I’ll also highlight that by opening the JV with Ohio STRS, we are creating an outlet for assets that otherwise did not fit in the BDC. So we have some excellent senior secured assets that we source in the WhiteHorse platform that are priced at LIBOR 500 to LIBOR 650. Historically, anything priced under a LIBOR 650 would not go into the BDC, but in the JV structure, with the leverage that comes from the JV structure, those assets can be profitably invested. And so that gives us an investing outlet for the BDC that -- will give us, if it gets approved, an investing outlet for the BDC that we did not have before that will allow more assets, more diversity and more senior secured loans to come into the overall portfolio.

Okay. Yes, that definitely makes sense. And then just one more for me before I’ll hop back in the queue. You’re already at that 75% first-lien target mix. But you kind of mentioned the discussions you’re having with JPMorgan about maybe taking on more leverage on that facility as you improve your portfolio mix. Just wondering, if you see that number migrating materially higher from 75% going forward? Or if that’s still kind of a target for the BDC?

I would tell you that I would set a soft target of 75% first lien plus or minus 5%, subject to the nature and the quality of the deals we see. Some second-lien assets are levered 6.5 times with a 4.5 times attachment point and some second-lien assets are levered 4.25 times with a 1.5 times attachment point and those two risk profiles assuming the companies with the same or completely different risk profile. And so second-lien assets can be very, very attractive. So I can’t set a firm number, but directionally speaking, where we have gone is where we intend to be, and directionally speaking, we would move our maximum concentration of second-lien assets down in the JPMorgan facility to something that is more aligned to what we expect to do ongoing.

Your next question comes from the line of Mickey Schleien of Ladenburg.

I wanted to just follow up on the joint venture project. We’ve seen other BDCs actually unwinding those JVs because now you’re allowed higher on balance sheet leverage. So what aspects of this JV are driving you to go that route as opposed to just using the higher allowed leverage under the amendment to the ‘40 Act?

So Mickey, and it’s a great question. The economics of putting a LIBOR 600 deal on the balance sheet of the BDC are such that the fees of the BDC are then charged directly on the asset. In the JV structure, the fees of the BDC are only charged on the invested capital and not on the underlying asset. So in the JV structure, a LIBOR 600 asset that would not be particularly accretive, it would be only gently accretive on the direct balance sheet, becomes much more accretive because you’re only paying the fees on the invested capital at the bottom of the JV. So the JV allows us to take these LIBOR, again, 500 to LIBOR 650 loans, but I would estimate that the average pricing will be LIBOR 575 to 600 and to include them on the BDC balance sheet in a manner which is highly accretive to income and much more accretive to income than it would be if those assets were put directly on the balance sheet, not in the JV.

And just conceptually, it would seem with all the cash that you have on your balance sheet now, at least in theory, you could fund or partially fund the JV with cash, is that in the works or you don’t have loans to contribute, so I’m just curious how you’re thinking about funding?

Yes. So over time, as the JV is deployed, we expect that we will have a plenty of availability to fund it. It is funded under the 30% bucket. When fully deployed, the BDC will have about 700 million of assets, so that bucket would be over $200 million, and we only plan on using, at the moment, 75 million of that for the JV. So there should be ample capital available both broadly and under the 30% bucket for the JV investment.

And just a couple more questions, if I might. Exits were fairly meaningful this quarter, I should say, exits and repayments. I’m curious whether the higher LIBOR is driving your borrowers to term out their borrowings, perhaps somewhere other than in the BDC sector. Have you seen that trend occurring yet? And who would be the lenders if that is happening?

No. The rise in LIBOR is not driving the change. The largest repayment we had was Intermedia. Intermedia was a loan that was repaid because the second-lien loan that was priced at LIBOR 950 was refinanced into our first-lien loan that was priced, I think, at LIBOR 600. So it’s the general aggressiveness of the market that leads to some of these loans getting repaid. We, in general, not always, but in general, are booking directly originated assets and the nice thing about the lower mid-market directly originated assets is they are much less subject to the large market trends. So Intermedia was a second-lien loan in a larger company. It was a mid-market company, not a lower mid-market company. And any of the deals that we have in the mid-market as opposed to the lower mid-market are more subject to the risk of refinancing based on the velocity of transactions in that market. That said, the majority of deals on our portfolio, the vast majority of deals that are in our pipeline, the mandated pipeline, our transactions that are lower mid-market, we define lower mid-market as 40 million of EBITDA and below, and that lower mid-market has much less repayment pressure than the mid-market does.

My last question is related to interest rates. Do you have a sense of how much interest rates -- how many more Fed rate increases can the lower middle market handle before you start to get concerned about your borrowers capacity to service their debt?

Mickey, in my opinion, the biggest risk of interest rates are highly leveraged transactions, right. If you’re levered 6, 7 or even 8x, a rise in LIBOR has a very material impact on your borrowing costs and a rise in LIBOR that could be beyond what people are expecting could have negative -- very negative consequences. We really strive to keep leverage levels on both our non-sponsor and sponsor transactions in check. I will tell you that, in general, on our non-sponsor transactions, leverage is between 2 and 4x and a lot of the transactions are levered, call it, 2 or 3 quarters at 3.5x. And in the sponsored mid-market where leverage is typically 5.5 to 7.5x, we do not typically play and instead focus on the off-the-run lower mid-market the firms that tend to be less covered by the larger financing entities out there. And as a result, the leverage on our sponsor transactions tend to run between 3.5x and 5.5x. So by keeping leverage multiples in check, I think it’s public information that the average leverage multiple of the deals that have gone into the BDC is only 3.2x. But by keeping leverage multiples in check, we keep the sensitivity of our portfolio to rising interest rates at a much lower level than many other people in the marketplace.

[Operator Instructions] Your next question comes from the line of Chris Kotowski of Oppenheimer.

I was -- when you said it would take a full roughly a year to fully deploy the capital, were you referring to the cash that you have from the Aretec sale and the pay downs or were you referring to getting to the full 1 to 1.25 leverage?

I’m referring to getting to the full 1.25x leverage. There’s about $200 million of capital that needs to be deployed. If we raise, and by the way, I’m open to listening to what investors and analysts think, but if we raise the maximum amount of the deal that we put in the BDC, which is now sort of targeted at a max of $20 million with a harder max of $25 million, if we raise that, we could deploy the capital more quickly. But I still believe that the most prudent thing to do for the BDC is to use this cash and this increase leverage to continue to increase diversity. And so I don’t intend to change the investment policy of the BDC. So when you factor in normal repayment along with the fact that we have call it $200 million of cash approximately to deploy, we’re estimating that, that will occur over the next year.

Okay. And you referenced the possibility of having to use some of the Aretec gain for a special dividend. And I guess, I’d say, given your NAV preservation track record and coverage of dividends, one would normally expect to see your stock trading at a premium to NAV, but it’s trading at a quite significant discount, and I was wondering, could -- would you consider using any of that excess capital for share repurchases rather than dividend -- special dividends?

I have no idea why our shares trade at the level they do given the underlying factual data about NAV preservation and the earnings of the dividend. But if our shares did continue to trade at a material discount to NAV, the manager and the Board of Directors would consider allocating capital to repurchase shares at that discounted price.

Yes. I mean, just from my point of view, that would be the gift that keeps on giving as opposed to a onetime dividend as a onetime dividend.

Yes. I understand, and we can only react to what we see go on in the marketplace. But recently -- quite recently, the shares have been at more than a 15% discount to NAV. Again, I don’t know any reason why they’re trading at that level, but if they continue to trade at that type of discount, there would be discussion. I can’t predict how that discussion would come out, but there would be discussion around allocating capital to the repurchase of shares.

At this time, there are no further questions. We thank you for participating in WhiteHorse Finance’s Third Quarter 2018 Earnings Conference Call. You may now disconnect your lines, and have a wonderful day.