WhiteHorse Finance, Inc. (WHF) Q1 2019 Earnings Report, Transcript and Summary

Good morning. My name is Brandy, and I'll be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance First Quarter 2019 Earnings Conference Call. Our host for today's call is 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 p.m. Eastern Standard Time. The replay dial-in number is 404-537-3406 and the PIN number is 2548319. [Operator Instructions]. It is now my pleasure to turn the floor over to Sean Silva of Prosek Partners. Please go ahead, sir.

Thank you, Brandy, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's first quarter 2019 earnings results. Before we begin, I would like to remind everyone that certain statements, which are not based on historical facts made during this call, including any statements relating to financial guidance, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties, these are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. WhiteHorse Finance assumes no obligation or responsibility to update any forward-looking statements. Today's speakers may refer to material from the WhiteHorse Finance first quarter 2019 earnings presentation, which was posted to our website this morning at 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 first quarter operating performance and then Ed will review our financial results, after which we will take your questions. I'm pleased to share that Q1 was another solid quarter for WhiteHorse Finance in all material areas. GAAP net interest income for the quarter was $7.6 million or $0.37 per share and core net interest income was $0.365 per share, more than covering our $0.355 dividend. Ed will provide details on the reconciliation between GAAP net interest income and core net interest income during his prepared remarks. In addition, during the first quarter of 2019, we recorded an NAV of $15.33, a $0.02 decrease from last quarter. This small decline was primarily due to a decision to exit the troubled Outcome Health account, partially offset by small markups in the portfolio. In terms of core deal flow, I would note that historically, Q1 has been our slowest quarter with a lower rate of deal flow entering the system especially during the month of January. This year, due to market disruptions in November and December, deal flow was very light through March with our pipeline showing strong growth into April. Our performance during these market conditions underscore the value of our 3-tiered sourcing architecture, which is provided by our sponsor H.I.G. as we were still able to close 4 first-lien deals at attractive yields during Q1 while staying true to our disciplined approach to sourcing and underwriting. I'll elaborate on those transactions shortly. Our weighted average effective yield on debt investments decreased slightly to 11.7% as compared to 11.9% at the end of the prior quarter. This was driven by an increase in first-lien senior debt deals and a slight decrease on LIBOR. I'll now discuss our investment portfolio in more detail. As of March 31, 2019, the fair value of our portfolio was $468.4 million compared to $469.6 million reported at the end of the fourth quarter. Total investments remained relatively flat from last quarter due to the aforementioned seasonality and market conditions, which also delayed our ability to deploy proceeds from the Aretec sale. Despite those conditions during the first quarter, we closed 4 first-lien deals totaling $32.3 million, three were direct originations. And we also funded 1 small add-on during the quarter, a $2.9 million transaction to Planet Fitness. In addition, we refinanced our investment to JVMC Holdings Corp., which is also known as R.J. O'Brien. Aside from the refinancing, repayments and sales during the quarter totaled $38.5 million primarily driven by a full paydown on Caelus Energy for $17.3 million. With the successful exit of Caelus at par, WhiteHorse Finance has no direct exposure to the oil and gas market across the entire portfolio. We also exited our remaining position in Outcome Health. Our internal rate of return on that asset was approximately 5% over its life, which while disappointing, is a result we will settle for when considering our perception of the risk of the company going forward. We also reported partial paydowns on Alpha Media and ACT, the latter of which has already been paid down in its remaining position in full subsequent to the first quarter. We were able to collect a meaningful prepayment penalty of $900,000 or $0.045 a share on the full paydown of ACT in April. While this will be included in our second quarter results, it is indicative of our ability to source low-multiple, non-sponsor deals that also generate nonrecurring fees that jump beyond the contractual interest rate. Last quarter, we disclosed the markdown on StackPath to $0.82 on the dollar but also shared that StackPath's private equity owner had been meaningfully investing in the company to help improve its performance. As a result of those efforts, the sponsors sold some assets and reduced the debt on the company resulting in a $3.8 million par paydown of our loan in April. And the remaining portion of the loan to StackPath has been converted to a first-lien facility effective in the second quarter. Turning now to debt and leverage. Our portfolio had an average debt investment size of $9.5 million based on fair value with all but 3 of our portfolio companies falling at or below the upper range of our target investment size of $20 million. Our leverage ratio remained relatively flat over the quarter at 57%. As mentioned previously, we intend to carefully ramp up investments and manage WhiteHorse Finance at 1 to 1.25x leverage in the future. But the timing of this is dependent on market conditions. We will only book assets that meet our core credit standards. Regarding our pipeline thus far into the second quarter, we have closed 2 transactions with an additional 4 transactions mandated as well as an add-on transaction to an existing account, which would increase funding. However, as always, there could be no assurance that mandated transactions will close. At this time, 2/3 of our deal pipeline are sponsor deals and 1/3 are non-sponsor deals. The average leverage on those transactions is approximately 4x, which is indicative of our proprietary sourcing model, considering that average multiples in the market are much higher. In fact, in the last 2.5 years, none of the deals that we have closed have been levered above 6x. And in fact, in Q1 and Q2, all of the transactions that closed were first lien at leverage multiples between 2.5 - 2x and 5.5x. Within our portfolio, we've maintained the strong credit quality our investors have come to know us for as first-lien loans comprised 80% of our portfolio during the quarter. Our ability to maintain portfolio size and security composition despite low transaction volume across the market in Q1 is indicative of the strength of our origination capabilities and underwriting culture. We believe our infrastructure is a true differentiator for a BDC of our size, positioning us well to drive growth while deploying capital in a selective and disciplined manner in all market conditions. With that, I'll now turn the call over to Ed.

Thanks, Stuart. We recorded GAAP net investment income of $7.6 million or $0.370 per share. This compares to $8.0 million or $0.391 per share in the prior quarter. Core NII was $7.5 million for the quarter or $0.365 per share. This compares to $8.2 million or $0.398 per share in the prior quarter. As a result of approximately $600,000 of total net realized and unrealized losses in the portfolio this quarter, the capital gains incentive fee previously accrued but not yet payable was slightly reversed in the amount of $121,000 in Q1. Also included in our Q1 results is a management fee waiver on cash balances of $177,000 or $0.09 per share, which compared to Q4's waiver of 154,000 or $0.08 per share. After taking into account our net realized and unrealized losses in the portfolio, we reported a net increase in net assets resulting from operations of approximately $7 million or $0.34 per share for the first quarter. As of March 31, 2019, net asset value was $315 million or $15.33 per share, down from $315.3 million or $15.35 per share as reported for Q4. As Stuart mentioned, although our NII covered our quarterly dividend, we experienced approximately $600,000 in net realized and unrealized losses driven by our exit in Outcome Health, partially offset by small markups in the portfolio. Collectively, this drove $0.02 decrease in NAV during the first quarter. As it pertains to our portfolio and investment activity, the risk ratings of our portfolio saw one of our positions being upgraded to a 2 or a 1 rating. Turning to our balance sheet. We had cash resources of approximately $36.9 million as of March 31, 2019, including $6.2 million of restricted cash and approximately $85 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 March 31, 2019. The asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 275% at the end of the first quarter, well above our reduced requirement under the statute of 150%. Our net effective debt-to-equity ratio after adjusting for cash on hand was 0.45x as of the end of the quarter. Next, I'd like to highlight our quarterly distribution. On March 15, we declared a distribution for the quarter ended March 31, 2019, of $0.355 per share for a total distribution of $7.3 million to stockholders of record as of March 26, 2019. The distribution was paid to stockholders on April 3, 2019. This marks the company's 26th distribution since our IPO in December 2012 with all distributions at a rate of $0.355 per share. We expect to be in a position to continue our regular distributions. I'll now turn the call to the operator for your questions. Operator?

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

My first one, Stuart, can you just size the pipeline you highlighted in your prepared remarks? What was the total commitment for closed investments and for those pending?

I don't have the numbers in front of me. I don't have the numbers in front of me for the size of the investments we closed. I'd see if Ed and Joyson [ph] can perhaps pull that together while I'm speaking. The transactions that we are working on in the pipeline that are mandated without having the exact allocations so far would all be between $5 million and $20 million per deal. There is no transaction that we intend to allocate higher than the target level. And again, in terms of the 2 that are closed, since they're fact-based, I'm not going to share those numbers, we're able to pull them on this call or we can share them afterward.

Yes. Tim, so the Q2 closings so far is $21.5 million of commitments.

$21.5 million. Got it. Okay, appreciate those comments. And then I know, Stuart, prepayments can be lumpy. But just given your pipeline, what you've closed so far, what's pending and looking up further than that, how long do you believe it will take for you to deploy all Aretec proceeds and just be more fully invested?

That is a function of market conditions and competitive dynamics. I can't predict the future. All I can say is that the pipeline into Q2 is materially greater than the pipeline was in Q1. We have over 100 deals in our deal pipeline, of which 2/3, I mentioned earlier, are sponsor, 1/3 non-sponsor. But I can't predict conversion rates. So I can't predict the speed with which we deploy the Aretec money and get leverage up to 1 to 1.25x. But as soon as we can do it, subject to credit constraints and minimum yield hurdles, we will try to get there.

Understood. And then just sticking on kind of the competitive dynamic you mentioned, leverage multiples on new and pending commitments so far in the quarter, I believe you said was at 4x, which is just slightly above where your portfolio has been running on average. I'm just wondering if this is reflective of kind of the portfolio mix shifting towards more senior, the pipeline being largely sponsor or if it's a function of the competitive landscape and you feeling that comfortable with the credits but needing to kind of expand the box a little bit to win some deals.

So the 4x number is the average leverage across the over 100 deals in our total deal pipeline. In terms of the transactions we closed, for the most part, the leverage on our sponsor deals is between 3.5x and 5.5x, which we believe is a very normal leverage multiple that was going on in the marketplace in 2014, 2015, 2016. We have not been chasing multiples up. We've seen many transactions in the marketplace getting done at over 6x, over 7x and even 8x. And we have not engaged in any of those transactions. Our non-sponsor deals are - have significantly lower leverage on average. They typically are between 2x leverage and 4.5x leverage. And the non-sponsor deals, as previously shared, not only have lower leverage and lower loan to value, but they also have tighter covenants. And that's because in non-sponsor deals, you don't have the support of a private equity firm giving you the consistently professional management and the ability to support the company through the cycle. That said, I should note that when we do non-sponsor deals, we do look at the strength of the owners. And we have seen owners on a number of non-sponsor deals inject equity into those companies when they underperform. But 2 to 4.5x leverage on non-sponsor deals, 3.5 to 5.5x leverage on our sponsor deals is our normal transaction flow.

Got it. Appreciate those comments. And then can you just give us an update on maybe which industries you find most and least attractive right now and if new originations have been concentrated around any particular industry? And if so, if that's an effort to get more defensive, just kind of as we get further in the credit cycle or if it's a relative value play.

We are avoiding all deeply cyclical industries, avoiding Tier 1 auto, avoiding construction, avoiding brick-and-mortar retail. We believe that playing in a senior secured position in companies that have anywhere from no cyclicality to at the most moderate cyclicality is a prudent place to be for our shareholders. And even when we do deals that we think will have some cyclicality, we generally try to make sure we're working with a partner, either a wealthy owner or a sponsor who can and will support that company through a down-cycle. Our goal is to keep all of our assets performing and paying interest regardless of whether we're in an economic up-cycle or down-cycle. And we run a down-cycle analysis on every deal we do that presumes 1 year of benign economy and then a repeat of 2008 and 2009. And if the company couldn't continue to perform through a repeat of those years in our estimation and our projection, those are deals that we turn down, which is why you find us not being able to do any deep cyclicals in today's market because the market is levering cyclicals at levels that we think are uncomfortably high.

Your next question comes from Mickey Schleien of Ladenburg.

I wanted to follow up the data you were providing on the sponsor versus the non-sponsor business. Could you also give us a sense of how the average EBITDA of the borrowers in those two buckets compare?

Very similar, Mickey. I would say with the vast majority of the deals that we consider in both the sponsor and non-sponsor arena are between $10 million and $30 million of EBITDA. We will consider something a little bit under $10 million but rarely do so. And on the non-sponsor side, we will also pursue companies well above $30 million of EBITDA up to, I'd say, $30 million to $75 million. And some number of our non-sponsor transactions are for these larger companies with EBITDA above $30 million. But I would estimate that 80% of our flow or maybe even more than 80% of flow is to companies with EBITDA of $10 million to $30 million.

And Stuart, how would you compare the covenants that you were able to get in this market between sponsor and non-sponsor deals?

The sponsor deals that we do are generally set at a 25% to 30% discount to the sponsors' projections. Those sponsor deals usually have between 40% and 60% equity in them. And where those covenants are set is usually several turns inside of the equity value of the company. So it is our intention on our sponsor transactions that we will have covenant defaults that kick in while the sponsor still has a lot of equity value left in that company. There is a dynamic you may have heard of in the market, Mickey, called covenant-wide or covenant-loose, where there are people who are talking about the fact that they're getting covenants, but those covenants are set at 9 or 10 or 11x. We have not done any covenant-wide or covenant-loose transactions on our deals that are levered 3.5 to 5.5x, our covenants are more normally at between 4 and 6.5x. So we're doing very traditional, normal, what we think are tight covenants in our sponsor transactions, which is consistent with the behavior in the lower mid-market whereas as you know in the upper mid-market, $50 million to $100 million of EBITDA, covenants have all but disappeared and the market has gone covenant-wide, which we're not comfortable with. On our non-sponsor deals, the covenants are generally set at a 15% to 20% discount to the management case projections. Those management case projections are generally because most CEOs and CFOs are optimistic, are upward-sloping. And our covenants in our non-sponsor deals are almost always set at much lower levels than the covenants that you see on the sponsor deals.

Just a couple more questions. So credit spreads obviously widened dramatically in the fourth quarter and then they've tightened back up. I'm curious how that's impacting the launch of the senior loan fund and actually any updates you can give us on how that's progressing.

Yes. What occurred in the large-cap and upper mid-cap market in Q4 had virtually no impact at all on the core mid-market and lower mid-market. We did attempt to push up price on a couple of transactions in December based on what we saw going on in the large-cap market. And in every single case where we tried to do that, we saw those transactions go away to other lenders. So we did not see any liquidity squeeze or impact in our core markets. That said, our core markets have never gotten as aggressive as those large-cap markets. And so it makes sense that if you don't swing with the liquidity surges, then you don't swing back with the liquidity detractions. So our markets were very consistent. And we really have seen no particular change in pricing trends between Q4, Q1 or even into Q2. As with regards to JV, we are continuing to source assets that we would intend to have go into the JV. But because things have been slower than we would have desired, we are not yet ready to implement the JV and move assets into it. And we do not intend to do that until we have the right number of assets to efficiently open the JV and the right number of assets to leave the BDC in a proper investment position after those assets will move into the JV structure.

Has the JV secured its debt capital?

We have a debt provider who has approved the leverage for the JV. We are not toggling that on until we're ready to go. Because the moment we toggle it on, we would be paying both closing fees and unused capital fees. And we don't want to burden the BDC with those until we're ready to go.

And in terms of ready to go, do you think that could still happen this year?

It certainly could.

Okay. And then last question, just sort of a housekeeping question. Do the covenants in your existing credit facility and both of the notes outstanding that you have both issues of notes outstanding, do they accommodate leverage above 1:1?

Yes.

Your next question comes from the line of Chris Kotowski of Oppenheimer & Co.

I'm just kind of wondering philosophically how you think about employing the higher leverage. I mean, I guess there are 2 possible ways to go, right? One is that if you keep doing the same kind of assets that you've been doing at the same levels, but you're more highly levered than theoretically the core run rate of net investment income, it should be higher and it would support a higher dividend. And on the other hand, one could say, "Hey, 10% is a pretty darn good return, so let's just try to do that with lower risk assets." And kind of where do you stand philosophically on that spectrum? And how should we think about the earnings power of the company when it's fully levered?

So Chris, we have already implemented the lower risk conversion of the BDC. The BDC used to be about 50% second-lien loans with a number of the things that we did being syndicated credits that were at market leverage levels. We are now almost purely a directly originated model, bringing in proprietary deal flow that meets our very strict credit standards. And we expect to run - right now, we're 80% first lien. But we expect to run it at typically more like 75% first lien. And we will do that at the higher leverage levels. You can run models on what we have been booking as pricing and the implementation of the JV and what that does for overall yields in the portfolio. And depending on what you assume for asset yields going forward, if we are running at 1 to 1.25x leverage, there is no question that the core amount of earnings of the BDC will rise. And what I've said on prior calls and it's still true, when we get there and we actually see what the core earning power of the BDC is at that 1 to 1.25x leverage based on the reality of the then current spreads in the marketplace, we will make a determination as to whether it would be prudent and advisable to increase the dividend. But at the moment, our focus is let's make sure we earn the dividend on an annual basis, as much as possible try to earn the dividend every quarter, although I've shared with the market the ability to earn the dividend every quarter is dependent upon waiver fees, amendment fees, prepayment penalties, like the one I talked about that we got on ACT this quarter. But the core earning power before waiver fees, amendment fees and prepayment penalties will be changing as we book more assets at approximately a 75% first-lien ratio going forward.

Your next question comes from Rick Shane of JPMorgan.

When we look at your trend on spreads, there was a little bit of compression sequentially. Is that just a function of lower origination and repayment activity this quarter driving a little bit less discount accretion?

I'll make my comment and then leave it for Ed to say anything further. My understanding is that the small decrease in the average yield is partially driven by the fact that LIBOR has come down a little bit and then partially driven by the fact that we are doing increasing amounts of first-lien deals. And the first-lien deals have lower spreads than the second-lien deals. So it is a modest compression of yield directly resulting from the fact that we've changed the risk profile of the assets that we're putting in the BDC. Ed, anything else you want to add?

No, I agree with those comments.

Okay. Great. And so when you look at sort of the run rate spread, given the shift, the modest shift in the portfolio, the shift in the portfolio, this is probably a pretty good level to be looking at and that gives you the confidence in the ability to sustain the dividend?

Yes. Based on everything that is going on right now and historically, we feel like we are able to earn our dividend on an annual basis. And again, as we book more assets and increase leverage, that is projected to increase the earning power of the BDC. And based on how that actually plays out, we will discuss whether the dividend is at the right level or should be moved.

There are no further questions at this time. Thank you for joining the WhiteHorse Finance First Quarter 2019 Earnings Conference Call. You may now disconnect.

Great. Thank you.