WhiteHorse Finance, Inc. (WHF) Q1 2022 Earnings Report, Transcript and Summary

Good afternoon. My name is Britney, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance First Quarter 2022 Earnings Conference Call. Our hosts for today's call are Stuart Aronson, Chief Executive Officer; and Joyson Thomas, Chief Financial Officer. Today's call is being recorded and will be made available for replay beginning at 5:00 p.m. Eastern Time. The replay dial in number is 402-220-1122. No passcode is required. [Operator Instructions]. It is now my pleasure to turn the floor over to Robert Brinberg of Rose & Co. Please go ahead.

Thank you, operator, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's First Quarter 2022 Earnings Results. Before we begin, I would like to remind everyone that certain statements, which are not based on historical facts made during this call, including any statements relating to financial guidance, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Because these forward-looking statements involve known and unknown risks and uncertainties, these are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. WhiteHorse Finance assumes no obligation or responsibility to update any forward-looking statements. Today's speakers may refer to material from the WhiteHorse Finance first quarter 2022 earnings presentation, which is posted on our website this morning. With that, allow me to introduce WhiteHorse Finance's CEO, Stuart Aronson. Stuart, you may begin.

Thank you, Rob. Good afternoon, everyone, and thank you all 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 from the period ended March 31, 2022, which can also be found on our website. On today's call, I will begin by addressing our first quarter results and current market conditions, and then Joyson Thomas, our Chief Financial Officer, will discuss our performance in greater detail, after which we will open the floor for questions. I'm pleased to report a strong first quarter performance for 2022. Q1 GAAP net investment income was $8.5 million or $0.368 per share. Core NII, after adjusting for a $0.6 million capital gains incentive fee reversal, was approximately $7.9 million or $0.344 per share. NAV per share at the end of Q1 was $14.99, representing a decrease of $0.11 from Q4 2021. This decline was primarily due to realized losses associated with the sale of our investment in Grupo HIMA, which we noted earlier in our portfolio update press release on May 3, 2022, partially offset by market adjustments from the restructuring of PlayMonster and net mark-to-market gains across the portfolio. Turning to our portfolio activity for the quarter. Gross capital deployments in Q1 totaled $83.6 million, which eclipsed our previous record for the highest level of gross deployments in any first quarter in our history. Of this amount, $69.5 million was funded into 6 new originations and the remaining $14.1 million was funded into add-ons of existing portfolio investments. Gross deployments were partially offset by repayments and sales of $45.1 million, primarily driven by 5 full realizations and partial sales in several credits as we look to create capacity and optimize the BDC's portfolio for higher-yielding credits we're seeing in our pipeline. This all resulted in net deployments of $38.5 million. As a result of these deployments and repayments, along with other factors at the end of Q1, the company's net effective leverage was 1.30x compared to 1.31x in Q4 of 2021. At this leverage level, we are modestly under our 1.35x limit and well within our target range. As anticipated and discussed in our last earnings call, many of the Q4 '21 delayed repayments have begun to come through. And in addition to the payoffs and sales that occurred in Q1, the company has already received an additional 3 full repayments totaling $45 million subsequent to quarter end. Of our 6 new originations in Q1, 4 were sponsor and 2 were nonsponsor with an average leverage level of 4.7x, which is relatively modest when compared to other middle market lenders. I note that all of these deals were first lien and at the end of Q1, more than 96% of our debt portfolio was first lien and 100% was senior secured. We continue to look to add second lien loans to balance our portfolio but have found few that are within our conservative risk return parameters. Given the shortage of second lien loans that meet our risk return standards, our portfolio is now approximately 3.5% second lien loans compared to our target level of up to 15%. As I shared on the last call, so long as our portfolio remains heavily concentrated in first lien loans, which have lower risk profiles but also lower returns than second lien loans, we expect to continue to run the BDC up to 1.35x leverage in order to help the BDC consistently earn its $0.355 quarterly dividend. With that in mind, I'll now step back to bring our entire investment portfolio into focus. Although we had strong net originations during the quarter, the fair value of our investment portfolio was $800 million at the end of the first quarter, a decrease from $819 million at the end of Q4 2021. The decrease was a result of asset transfers to the STRS JV, partially offset by net mark-to-market increases in our portfolio. The weighted average effective yield on income-producing investments was 9.2% at the end of the first quarter, slightly above the Q4 level of 9.1%. We are pleased to report that as of the end of Q1, we had no debt investments on nonaccrual status. This was a direct result of our decision to exit our distressed investment in Grupo HIMA as well as our restructuring efforts in PlayMonster that occurred during the quarter. As we disclosed on May 3, 2022, we exited our position of Grupo HIMA via a sale, which resulted in net realized and unrealized losses of $6.9 million in Q1. On a life-to-date basis, after accounting for both principal and interest payments over time, we recovered approximately 75% of the capital invested in Grupo HIMA, resulting in a rare credit loss in our BDC's history. Although we are disappointed with the final outcome of HIMA, we concluded the best option was to exit the deal amidst a complicated situation with a number of contingent liabilities and instead focus our resources in managing our directly originated assets that make up the majority of our portfolio as well as sourcing future originations. Regarding PlayMonster. As shared during last quarter's call, WhiteHorse and one other lender took control of the company. The PlayMonster deal was restructured in Q1, with our prior loan replaced by a new interest-bearing term loan in addition to preferred and common equity. We expect the process of turning around the company and exiting to take several years, and we remain optimistic of our ability to generate a strong recovery over time. As a result of the HIG Capital family, we have access to HIG private equity professionals to help us manage this investment. At the end of Q1 '22, we have seen some improvements, which led us to mark up the investment value to the equivalent of 75% of our cost basis from 65% at the end of Q1 '21. The vast majority of our portfolio companies have navigated supply chain and labor disruptions well and have generally been able to pass cost increases through to their customers. Given the modest leverage levels that we underwrite our loans to, both from an EBITDA as well as an operating cash flow perspective, we expect the majority of our portfolio companies to be able to service our debt in this rising interest rate environment, as reference rates rise 200 basis points or even more. Holistically, our own investment portfolio is well positioned to benefit from such rising interest rates, given that approximately 99.6% of our debt portfolio is comprised of floating rate debt investments. We believe the conservative nature of our underwriting process, including the modest leverage levels to which we underwrite our loan investments, is a key differentiator versus lenders with higher levered portfolio companies that may experience greater difficulty servicing debts as interest rates increase. Additionally, we continue to successfully utilize our joint venture with STRS Ohio, which generated investment income to the BDC of approximately $2.6 million in Q1 as compared with $2.2 million in Q4 of 2021. During the first quarter, we transferred $82.7 million in investments to the STRS JV, including 6 new deals, 5 add-ons and the remaining portion of 3 deals previously transferred in exchange for cash of $57.7 million as well as $25 million in-kind investments into the JV. The fair market value of the JV's portfolio was $312.8 million as of March 31. The JV's portfolio had an average unlevered yield of 7.9% compared to the end of Q1 -- sorry, it was 7.9% at the end of Q1, consistent with the Q4 '21 average yield of 7.9% as well, with a portfolio size at that time of $259.5 million. The JV's portfolio is currently comprised solely of first lien senior secured loans. We remain pleased with the income contribution from the JV. The JV has produced an average annual return on equity in the low teens. We believe the JV supports higher returns for shareholders and is particularly relevant, given the current market backdrop. As discussed on our last call, we closed an incremental $25 million commitment to the JV in the beginning of Q1, which translated into approximately $62.5 million in additional investment capacity for the JV. I do note, however, that as we stated in our prior earnings call, nearly all this additional capacity has already been put to work, demonstrating the continued strength of our origination activity. Given the JV's return on equity, we continue to consider further funding commitments to the JV as we seek to increase our exposure to this highly accretive earnings stream. In the meantime, the market remains quite busy, and our pipeline for future deal flow remains strong. The sourcing process is still competitive, particularly for on-the-run sponsor deals, where pricing leverage and documentation terms have returned to pre-COVID levels despite the macro pressures such as inflation and international conflict. Documentation terms and EBITDA adjustments in the off-the-run sponsor market or the smaller sponsors are less aggressive than the on-the-run sponsor market. We continue to have significant off-the-run sourcing advantages in the marketplace due to our presence in 12 regional markets. Consistent with prior quarters, there is also less competition for nonsponsored deals, where we continue to source attractively priced transactions at modest leverage levels. We can -- while we expect our pipeline activity levels to remain high, we generally have a cautious approach and continue to underwrite to conservative downside scenarios, including a potential recession in the next 12 months. Thus far into Q2, the company has closed 2 transactions and currently has visibility for over 8 additional mandated new deals and add-on transactions, although there can be no assurance that any of these will close. This exceptional pipeline growth and these mandated deals are enabling the BDC to drive portfolio growth and expand our investment in the JV, which will ultimately lead to higher income and greater coverage of our dividend. I know, however, that the platform has more origination activity than the BDC can accommodate and given our goal to source higher-yielding loans, some of these deals in pipeline may not make it into the BDC's portfolio as we continue to manage our leverage level at a targeted max of 1.35x or below. To that end, the BDC has turned down 4 origination opportunities during the first quarter due to capacity constraints. In closing, we are well positioned to continue executing our three-tiered sourcing approach and rigorous underwriting standards for the remainder of this year and beyond, and we're highly focused on sourcing higher-yielding opportunities to generate additional investment income to further support our dividend. Our portfolio as a whole remains very high quality and healthy. At the conclusion of the first quarter, we are very optimistic looking forward. While we do remain cautious about cyclical industries, the lingering effects of the pandemic, the war in the Ukraine as well as the competitive state of the credit markets, we believe we have built a very strong team and a solid sourcing and underwriting process. Further, the additional capital we raised late last year and the incremental contribution to the JV and the full effect of earnings from the deployments in Q1 provide a strong tailwind for our financial performance moving forward. With that, I'll turn the call over to Joyson for additional performance details and a review of our portfolio composition. Joyson?

Thanks, Stuart, and thank you all for joining today's call. During the quarter, we recorded GAAP net investment income of $8.5 million or $0.368 per share. This compares to $7.5 million or $0.331 per share in the fourth quarter of 2021. Core NII was approximately $7.9 million or $0.344 per share after adjusting for a $0.6 million capital gain incentive fee reversal. This compares to Q4 2021 core NII of $7.3 million or $0.322 per share and a quarterly distribution of $0.355 per share. Q1 fee income increased slightly quarter-over-quarter to $0.5 million from $0.3 million in Q4. The increase was due to higher prepayment amendment activities during the current quarter. For the quarter, we reported a net increase in net assets resulting from operations of $5.7 million, which is a $2.6 million increase from Q4 '21. Our risk ratings during the quarter showed that 90.1% of our portfolio positions carried either a 1 or 2 rating, consistent with the prior quarter. As a reminder, a 1 rating indicates that the company has seen its risk of loss reduced relative to initial expectations and a 2 rating indicates the company is performing according to initial expectations. Regarding the JV specifically, we've continued to grow that investment. As Stuart mentioned earlier, we transferred 6 new deals, 5 add-on transactions and the remaining portion of 3 previously transferred deals, aggregating to approximately $82.7 million in exchange for a net investment in the JV of $25 million as well as cash proceeds of approximately $57.7 million. As of March 31, 2022, the JV's portfolio helped positions in 33 portfolio companies, with an aggregate fair value of $312.8 million compared to 28 portfolio companies at a fair value of $259.5 million in Q4 '21. The investment in the JV continues to be accretive to the BDC's earnings. As we have noted in prior calls, the yield on our investment in the JV may fluctuate period-over-period as a result of a number of factors, including the timing and amount of additional capital investments, the changes in asset yields in the underlying portfolio as well as the overall credit performance of the JV's investment portfolio. Turning to our balance sheet. We had cash resources of approximately $21.3 million at the end of Q1, including $18.8 million in restricted cash and approximately $51.2 million of undrawn capacity under our revolving credit facility. During Q1, we amended the terms of our revolving credit facility to permanently upsize the credit facility to a total commitment size of $335 million. This provided us significant flexibility as we accounted for timing differences between anticipated prepayments and originations. And we still have a remaining core future upside of the credit facility to a total of $375 million should we so choose. As of March 31, 2022, the company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 173.4%, which is above the minimum asset coverage ratio of 150%. Our Q1 net effective debt-to-equity ratio after adjusting for cash on hand was 1.30x as compared to 1.31x in the prior quarter. Before I conclude and open up the call to questions, I'd like to highlight our distributions. On March 3, 2022, we declared distribution for the quarter ended March 31, 2022, $0.355 per share to stockholders of record as of March 25. The dividend was paid on April 4, 2022, marking the company's 38th consecutive quarterly distribution. This speaks to both the consistent strength of the platform as well as a resilient fuel sourcing capabilities and be able to create a well-balanced portfolio, generating consistent current income. Finally, this morning, we announced that our Board declared a second quarter distribution of $0.355 per share to be payable on July 5 to stockholders of record as of June 20, 2022. This will mark the company's 39th consecutive quarterly distribution paid since our IPO in December 2012, with all distributions consistent at the rate of $0.355 per share per quarter. As we said previously, we will continue to evaluate our quarterly distribution, both in the near and medium term based on the core earnings power of our portfolio, in addition to other relevant factors that may warrant consideration. With that, I'll now turn the call back over to the operator for your questions. Operator?

[Operator Instructions]. We will take our first question from Mickey Schleien with Ladenburg.

I want to start by thanking you for the depth of your prepared remarks, Stuart, because it allows us to focus on the bigger picture without having to ask all these housekeeping questions. So with that in mind, Stuart, given your long track record in the credit markets, I'd really be interested in hearing your outlook for the rest of this year and going into next year in terms of the default environment considering all the headwinds that we're facing in the credit markets.

Yes, Mickey, good day, and a great question. It's a complicated question. I would tell you that there are numerous headwinds that everyone is aware of, rising labor costs, rising raw material costs, rising transportation costs, anything with oil as an endpoint is impacted there. While we have no direct exposure into Russia or Ukraine, it turns out, one of our companies use as a type of cooking oil that primarily came out of Eastern Europe and prices of that cooking oil have been impacted by the war. So they're now switching to different cooking oils and trying to deal with that. So there are many headwinds, but what we're seeing across our portfolio, in almost every single company, is that those rising costs and headwinds are being absorbed by price increases that are being pushed through. So I do believe we are in an inflationary spiral. I don't see it slowing down yet based on what's going on in our portfolio. We have one portfolio company in the food business that is currently pushing through its fourth price increase, and the price increases have all been reasonably significant. At WhiteHorse, based on the insights that we get from our parent company, HIG, we do think that there is real risk of recessionary environment, in both Europe and then ultimately, the U.S., although Europe seems to be ahead of the U.S. in terms of that. Ahead meaning more pressure in Europe. And we are underwriting all of our transactions to the possibility or even likelihood of a recessionary environment within 12 months. That means that since others are not doing that and others are not doing that, we are, at the moment, pretty uncompetitive on companies that are cyclical or even moderately cyclical. We've had a lot of those deals come in where the leverage we offered was significantly lower than what we're seeing going on in the marketplace. And so we are surprised that some number of our competitors do not seem to be underwriting to a cyclical downturn even though we are. Right now, we are focused on doing companies that are noncyclical or lightly cyclical, and we have a solid pipeline of those transactions. And then importantly, in the face of the pressure of rising interest rates, the average leverage we put on our deals historically is in the mid-4s on an EBITDA basis and the mid-5s on a cash flow basis. And so whether LIBOR or SOFR is at 50 basis points or 350 basis points, those companies, in general, should be able to service our debt with no problem. It's companies who take on leverage of 6.5, 7.5, 8.5x that have a lot more exposure to rising interest rates. So we think our strategy of modest loan to value, modest leverage and again, leverage not only on an EBITDA basis, but on an operating cash flow basis, has been preparing us well for what we see going on right now and what we expect to happen in coming years. In terms of defaults linked to inflation, there's nothing that we see on the horizon right now. Companies in our portfolio are dealing with their individual credit realities. But in the case of inflationary environment, again, virtually every company has had success in passing through price increases. And most of the companies are, as Joyson indicated, performing pretty darn well.

I appreciate that explanation, Stuart. It's really helpful. And to follow up on your answer. You have 3 companies whose debt investments would seem to be on credit watch, PG Dental, Crown Brands and SureFit. Is there anything thematic amongst those 3 related to your comments about inflation and cost inputs? Or are these more idiosyncratic issues to those 3 companies?

PG Dental dealt with issues during COVID and is still dealing with labor issues that the owners of the company are trying to resolve. The owners of that company have continued to support the company with additional equity. And so we feel good about the ownership and their support. Crown serves commercial kitchens. Restaurants are, of course, doing much better, but they also serve the commercial kitchens of hotels and cruise lines. And hotels and cruise lines have not returned to normal yet. So that company continues to have pressure on the cash flows, although they're doing much better than they were during the depths of COVID. The owner there has also supported the company with increased equity commitment as recently as the first quarter. And SureFit is a company that sells to brick-and-mortar retailers and has had some supply chain issues. They have passed through price increases. As I indicated, virtually all the companies have, but they are dealing with supply chain limitations on timing of product arrival, and that has had some impact. So one way or another, it all relates back to COVID supply chain labor, but they are very different situations among the 3.

I understand. My last question relates to your comment about second -- the lack of second liens. When we think about the broad HIG platforms, are there opportunities that the BDC, perhaps to add another vertical, it could be things like equipment finance or ABL lending or even investing in CLO equity, which tends to be generating very high cash flows right now. Is there any likelihood of those things occurring? Or are you just going to stick to your knitting and wait for the market to come back to you?

Well, Mickey, we're largely out of investing capacity in the BDC. So any new initiative that was targeted, putting a lot of assets on the books would be very difficult. Equipment lending and ABL, we don't think that the returns are particularly attractive in those sectors right now from what we see. There's plenty of competition and pricing has been bid down. We see the best ROE that we're getting, being the JV. We are getting low to mid-teens returns out of the JV. And as the BDC is full, we are no longer putting any assets with 500 pricing, 550, 575 is not going into the JV at all. And the JV is now positioned to take on higher-returning assets, with spreads from LIBOR 600 to LIBOR 650. So if anything, I would say, if we have available capital, we may allocate a little more capital into the JV and increase the JV cash flows, which, as you've seen, have grown strongly and have been a stable source of increased earnings for the BDC investor.

Yes, they certainly have, and congrats on that performance. Stuart, those are all my questions this morning -- this afternoon.

Thank you, Mickey.

We will take our next question from Bryce Rowe with the Hovde Group.

Maybe just a follow-up to the discussion around the JV. And obviously, it's growing as a percentage of your portfolio and certainly appreciate the ROE, is there a level at which you start to get uncomfortable with the size of the JV relative to the overall portfolio?

The JV is well diversified. The JV is all senior secured assets. So the JV as an investment vehicle is very consistent with the investing philosophy of the BDC. The only thing that is ultimately a pressure point is the 30% bucket for assets of that type that aren't compliant with the overall guidelines of BDC investing. And as a result, there's a little more money, because we want to leave a big cushion, there's a little more money that we'd be willing to consider putting towards the JV, probably something in the range of $15 million to $25 million. But after that, we believe the rest of that as cushion for the 30% bucket. But again, the JV as an entity is very consistent with our investing philosophy and very accretive for the shareholders of our BDC.

Okay. Yes, makes sense. Let's see. Let's maybe shift to the rate environment and the impact on the BDC. When you look at your portfolio, can you remind us where the weighted average floor is in the portfolio? And at what point do you start to see some positive impact from higher rates?

Joyson, that's all yours.

Bryce, as it relates to the weighted average floor rate right now in the portfolio, it has held consistent over the last couple of quarters. So it's just above 1% at 1.03%, 1.04%. And the way to think about this, I think, is for every 100 basis points increase, we look -- we will look to have a net interest income contribution of about $4.9 million. So that's obviously inclusive of the additional accretion for -- or the additional interest income earned on our portfolio, net of the additional interest expense on our credit facility.

Okay. Okay. And Joyson, is the impact -- is it lagged? So this move above your average floor here in the second quarter, that will get reflected starting in the back half of this year?

Yes, I think there's a way to look at it. The -- a good portion of our portfolio does reset on a quarterly basis.

Yes. Okay. Okay. I think that's it for me. I think -- I appreciate all the commentary, Stuart and Joyson.

Again, we try to get feedback from all of you to understand what you want to hear from us and please continue to let us know so we can include as much transparency as possible in the public comments.

[Operator Instructions]. We'll take our next question from Robert Dodd with Raymond James.

On repayment activity. Obviously, last quarter, you talked about elevated prepayment income in the first half of the year. Obviously, that didn't happen in Q1 with the market volatility, et cetera. Some of that seems to have happened in Q2. You've already had $45 million in repayments. Do you expect kind of the same amount of prepayment income you were previously thinking, which you didn't give us a number, but conceptually concentrated in Q2? Or do you think the environment is going to result in some people -- some borrowers waiting even longer or just sitting on that current structures and not prepaying at all given where the market is right now?

I think it's the latter. We have seen several transactions, some private market and some involving SPACs that have unwound due to market conditions. And I think the pace of prepayments that we might have seen in 2022 will be muted compared to what they might have been based on a series of things that are going on in the market right now that are leading to less stability. I think we're going to still have a normal repayment stream. And in a normal year, about 3% of the assets in our pool repay. And so I think that is a guess, but a decent guess for what we'll see over the course of 2022.

Got it. On kind of following up to Bryce's question before I get to more conceptual. On the NII sensitivity, just from your [indiscernible] sale, which is that's interest income less interest expense delta. So does that sensitivity you gave, that 4.9, does that not include the potential impact of increased income from the JV, which obviously structurally is the same and would see, to the BDC, and would see a benefit if rates were to lie at the level the forward curve is currently pointing to?

Robert, that's correct. So this is looking at the BDC portfolio and not necessarily underlying to the JV. And so there would be further kind of excess when looking at the JV portfolio relative to its credit facility. And then obviously, in terms of just the time you need to get that income repatriated up to the BDC.

Got it. Got it. I appreciate that. Last one, if I can. Stuart, I mean, on the -- your outlook, obviously includes the possibility of a recession, that you were very clear. Thank you for all the detail on that. So if -- when we look at the forward curve as it is, I mean, it's come back a little bit, but it certainly doesn't appear to be forecasting any material reduction to say, '23 or anything like that. What do you think the possibility is that we get to '23 sometime, there is a recession, the Fed has kind of round-tripped and we're back to Fed funds at 50 than where we look like we're going by year-end here? Some rough question, but any color would be appreciated.

Robert, we recognize that there are forward curves, but the forward curves' accuracy is sporadic. And so we're underwriting to a conservative downside. We believe that the investors in the BDC don't want volatility, which is why we're in senior secured first lien loans for 96% of the portfolio. And we are trying to make sure we manage -- we've always underwritten to a potential repeat of the Great Recession within a couple of years of doing a deal. It's just we think we may be closer to that now than we've been in prior periods. And so we're modeling those in as soon as next year. If that happens, will the Fed change its policy? I think it depends on what we're seeing with inflation. There have been articles out that I've read about the risk of stagflation, and that is certainly a downside risk we're aware of, but of course, are hoping does not happen. But all I can say is we don't take the forward curves as anything more than one possibility for what may happen, and we tend to take a more conservative view then the forward curves might otherwise imply.

We have no further questions on the line at this time. I will turn the program back over to our presenters for any additional or closing remarks.

Great. Well, I thank everyone for taking the time to listen in and ask questions. And as always, as we prepare remarks for future quarters, if there are things that you'd like to hear as a part of the prepared remarks, please let us know before the call. That's both to the analysts and to the public investors. We're working hard to build a stable, safe portfolio that earns the dividend on a quarterly basis. And we will continue to do our best to deliver to our shareholders. Thank you very much.

This does conclude today's program. Thank you for your participation. You may disconnect at any time, and have a wonderful day.