WhiteHorse Finance Inc (WHF) 2022 Q2 法說會逐字稿

Good afternoon. My name is Katie, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Second 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 4:00 p.m. Eastern Time. The replay dial-in number is (402) 220-6059. No passcode is required. (Operator Instructions)

It is now my pleasure to turn the floor over to Jacob Moeller of Rose & Company. Please go ahead.

Thank you, operator, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's second 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 second quarter 2022 earnings presentation, which was posted to our website this morning.

With that, allow me to introduce WhiteHorse Finance's CEO, Stuart Aronson. Stuart, you may begin.

Thank you, and good afternoon, everyone. 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 for the period ending June 30, 2022, which can also be found on our website. On today's call, I'll begin by addressing our second quarter results and the current market conditions. Then Joyson Thomas, our Chief Financial Officer, will discuss our performance in greater detail, after which we'll open the floor for questions.

I am pleased to report solid second quarter performance for 2022. Q2 GAAP net investment income was $7.9 million or $0.339 per share Core NII was approximately $7.8 million or $0.334 per share after adjusting for a $100,000 capital gains incentive fee reversal. NAV per share at the end of Q2 was $14.95, representing a decrease of $0.04 from Q1 2022. Importantly, it remains very close to our initial underwriting price of $15 per share. This decrease was a result of some credit deterioration on a few accounts, along with markdowns, reflecting higher pricing in the lower mid-market.

Turning to our portfolio activity for the quarter. Gross capital deployments in Q2 totaled $48.1 million of this amount, $28.9 million was funded into 4 new originations and the remaining $19.2 million was funded into add-ons of existing portfolio investments. As we suggested what happened during our last earnings call, delayed repayments have begun to occur.

During Q2, total repayments and sales were $66.1 million, primarily driven by 5 full realizations with repayments outpacing origination activity and additional transfers of investments into the STRS JV, net effective leverage decreased to 1.8x at the end of Q2 as compared to 1.3x at the end of Q1. At this leverage level, we are below our target of 1.25 to 1.35x leverage.

Regarding the 5 realizations, we earned $6.7 million, including fees and interest which generated an aggregate IRR of 11.4% on the $59.7 million of aggregate capital invested into these deals. This attractive return for senior secured loans demonstrates the power of our sourcing model and highlights our ability to negotiate tight covenants and strong call protections. These repayments provide the BDC with nearly $50 million of investment capacity.

Looking forward, a number of borrowers have alerted us that they plan to make repayments in the third or fourth quarter, which will give us additional investment capacity. Given the change in marketplace pricing, which I will discuss later, we believe that in many cases, the repayment on historical investments will allow WhiteHorse to redeploy capital into higher-yielding investments. Of our 4 new originations in Q2, 3 were sponsored deals and one was a non-sponsored deal with average leverage of 4.7x. I note that all of these deals were first lien loans and had an expected average all-in rate of 8.1% with an effective yield of 9.7%, which was higher than the portfolio average at Q1.

At the end of Q2, 96.5% of our debt portfolio was first lien loans and 100% was senior secured. 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 in second lien loans, we expect to continue to run the BDC at up to 135 leverage. In order to help the BDC consistently earn its $0.355 quarterly dividend, which we have consistently paid since coming public.

With that in mind, I'll now send back -- step back to bring our entire investment portfolio into focus. After the effects of the STRS JV asset transfers as well as $3.5 million in net mark-to-market decreases, $1.9 million in realized gains, and $1.6 million of accretion. The fair value of our investment portfolio was $766.5 million at the end of the second quarter, down from $800 million at the end of Q1. The weighted average effective yield on our income-producing debt investments was 9.9% as of the end of the second quarter, which reflects a 70 basis point increase from Q1 level of 9.2%.

This increase resulted primarily from rising LIBOR and SOFR rates. We continue to utilize our joint venture with STRS Ohio successfully. The joint venture generated investment income to the BDC of approximately $3 million in Q2 as compared to only $2.6 million in Q1. The increase in JV income in Q2 was due in part to WhiteHorse's increased economic ownership of 66.67% compared with 60% in Q1.

During the second quarter, we transferred 1 new deal and 1 add-on investment to the STRS JV totaling $17.8 million. The fair market value of the JV's portfolio was $318.8 million as of June 30th. And at the end of Q2, the JV's portfolio had an average unlevered yield of 8.7%, above Q1's yield of 7.9%, and a portfolio size of $312.8 million. The increase in the unlevered yield is primarily due to rising base rates of LIBOR and SOFR. The JV's portfolio is currently comprised solely of first lien senior secured loans. The JV has produced an average annual return on equity in the low teens to the BDC.

We believe WhiteHorse's equity investment in the JV provides attractive returns for shareholders and is particularly relevant given the current market backdrop. Given the JV's return on equity, we continue to consider funding additional equity commitments to the JV as we seek to increase our exposure to highly accretive earnings stream. We are pleased to report that we have no investments on non-accrual status, and our investment portfolio remained stable during the broad market volatility in Q2. We did have both markups and markdowns in the portfolio based on improving or decreasing performance. But on average, the portfolio was stable.

Our well-diversified portfolio is weathering an economy experiencing several negative factors, including rising interest rates, rising raw material prices, rising labor costs, and rising transportation costs. Fortunately, to date, our portfolio companies have done a very good job of passing along these price increases. A couple of borrowers are having their margins squeezed, and we are certainly seeing a slowdown in consumer retail demand, which has led to modest increases in leverage in several portfolio companies. Additionally, our portfolio is overwhelmingly represented by non-cyclical or light cyclical borrowers, and we hold no direct exposure to oil and gas, auto or restaurants and very little exposure to the construction sector.

Since we generally serve the lower mid-market, we've been able to build a portfolio with average leverage at the portfolio company level of only about 4.5x. By keeping our portfolio company leverage low, our portfolio of companies are better able to cover their debt service in this rising interest rate environment. Thus far, rising interest rates have only had a modest impact on the debt service coverage for our portfolio companies. While the portfolio is holding up well, we are keeping a careful eye on demand characteristics, especially in the consumer sector. We have not seen many recessionary signs yet in our portfolio, but I should note that portfolio numbers are delayed by a lag in reporting typically 45 to 60 days after quarter end.

The modest leverage levels to which we underwrite our loan investments from both an EBITDA as well as an operating cash flow perspective is a key differentiator versus lenders with higher levered portfolio companies that may experience greater difficulty servicing debt as interest rates increase. We expect the majority of our portfolio companies to be able to service our debt in this rising interest rate environment. We believe our investment portfolio is well positioned to benefit from such rising interest rates given that almost 100% of our debt portfolio is comprised of floating rate investments. Given where 3-month LIBOR and SOFR contracts reset to around the end of June, we expect some organic earnings accretion starting in Q3. We'll also see the full impact of our increased ownership in the JV beginning in Q3.

The market, and by this, I mean the market for stocks, bonds, cryptocurrencies, and most other assets has corrected sharply with an emerging consensus view that the economy is in recession. Across the mid-to-lower mid-end of the market, in addition to rising prices, loans are being written to more conservative credit terms with tighter documentation and covenants. Total leverage on transactions is a 0.25 turn to 0.5 a turn lower than it was 3 to 6 months ago. That said, we have witnessed that several lenders have not yet adjusted to the new market pricing, which frankly is a bit unexpected.

There has also been a correction in the broadly syndicated market, creating opportunities for direct lenders, including BDCs to acquire syndicated bank debt at lower prices and much higher yields than a few months ago. We believe this environment is very attractive for making investments in larger, non-cyclical or marginally cyclical businesses. Our pipeline reached another record level, which enables us to be highly selective about which credits we pursue. While we expect our pipeline activity levels to remain high, we generally have a cautious approach and continue to underwrite to conservative downside scenarios.

We have been selectively taking advantage of market conditions and are positioned to benefit from both rising base rates and rising spreads. Thus far in Q3, the company has closed 3 add-on acquisitions and currently has visibility for 5 additional mandated deals and add-on transactions, although there can be no assurance that any of these deals will close. As I mentioned earlier, the timing of repayments has been fortuitous for the BDC as we have capacity to rotate into higher-yielding assets that combined with portfolio growth and the increase in our ownership in the JV should ultimately lead to higher income and greater coverage of our dividend.

At the conclusion of this quarter, we are cautiously optimistic for the second half of the year. While we remain concerned about cyclical industries and various economic headwinds, we believe we have built a very strong portfolio with a strong team and solid sourcing, and a responsible underwriting process. Further, we expect our additional capital capacity and unique 3-tiered deal sourcing capability to act as a strong tailwind for our financial performance moving ahead.

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, everyone, for joining today's call. During the quarter, we reported GAAP net investment income of $7.9 million or $0.339 per share. This compares to $8.5 million or $0.368 per share in the first quarter. Core NII was approximately $7.8 million or $0.334 per share after adjusting for a $0.1 million capital gains incentive fee reversal. This compares with Q1 Core NII of $7.9 million or $0.44 per share and the quarterly distribution of $0.355 per share. Q2 fee income increased slightly quarter-over-quarter to $0.7 million from $0.5 million in Q1. The increase was due to higher prepayment and amendment activities during the current quarter.

For the quarter, we reported a net increase in net assets resulting from operations of $7.3 million, a $1.6 million increase from Q1. Our risk ratings during the quarter showed that 84.8% of our portfolio positions carried either a 1 or 2 rating, a decrease from 90.1% in the prior quarter. As a reminder, a 1 rating indicates that a company has seen its risk of loss reduced relative to initial expectations and a 2 rating indicates the company is performing according to those initial expectations. Regarding the JV specifically, we continue to grow our investment.

As Stuart mentioned earlier, we transferred 1 new deal and 1 add-on transaction, which totaled $17.8 million. As of June 30th, the JV's portfolio helped positions in 32 portfolio companies with an aggregate fair value of $318.8 million compared to 33 portfolio companies at a fair value of $312.8 million in Q1. 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 $18.6 million at the end of Q2, including $9.4 million in restricted cash. As discussed on our last call, we amended the terms of our revolving credit facility earlier in the year to permanently upsize the credit facility to $335 million, which has provided us significant flexibility in accounting for timing differences between anticipated prepayments and originations. We also still have an accordion feature to upsize the credit facility to a total of $375 million should we so choose.

As of June 30, 2022, the company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act was 181%, which was above the minimum asset coverage ratio of 150%. Our Q2 net effective debt-to-equity ratio after adjusting for cash on hand was 1.18x compared to 1.3x in the prior quarter. Before I conclude and open up the call to questions, I'd like to highlight our distributions. On May 10, 2022, we declared distribution for the quarter ended June 30, 2022, of $0.355 per share to stockholders of record as of June 20. The dividend was paid on July 5, 2022, marking the company's 39th consecutive quarterly distribution. This speaks to both the consistent strength of the platform as well as our resilient deal sourcing capabilities in being able to create a well-balanced portfolio, generating consistent current income.

Finally, this morning, we announced that our Board declared a fourth quarter distribution of $0.355 per share to be payable on October 4th, 2022, to stockholders of record as of September 20th, 2022. This will mark the company's 40th 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 turn the call over to the operator for questions. Operator?

(Operator Instructions) Our first question will come from Mickey Schleien with Ladenburg.

Stuart, I see that the -- per your internal credit rating system, the fair value of investments performing below expected the 3 category rose from around 9% to 14% of fair value. Are there any specific investments in there that you could highlight? And any trends that you're seeing across the portfolio that accounted for that change?

Yes. Good to see you this hour hear from you this afternoon. On your question, you will not be surprised to hear that some of our companies are experiencing supply chain pressures and also increased labor costs and then are seeing demand slowdown as retailers are being slower to restock inventory because inventory levels are too high, and there is a general slowdown in consumer demand.

So as we are probably in a recession now, and we are seeing that show up in lower demand. Some companies are seeing higher leverage, as I indicated in my prepared remarks. It's not that many companies, which is why the number of 3s has only increased by 5%. But there are some consumer-facing companies in our portfolio where the leverage has kicked up by a turn or 2. Nothing that risks at the moment being on non-accrual in terms of new situations. But we definitely are, as I said, seeing a slowdown in consumer demand and a slowdown in retailers restocking inventory and that is putting pressure on some companies…

I'll also just highlight to you that in terms of the overall risk ratings, as we had mentioned, the main drop went from portfolio companies being rated 1 or 2 that may have shifted down to a 3. There were 4 portfolio companies that did shift down to a 3 from a 2, Bulk TV, American Crafts, Arcserve, StorageCraft, and Award Town. And then as Stuart alluded to, really not much movement in portfolio companies moving down to a 4. There was one, a very small position Crown Brands. And...

We're working with the owner of the company to potentially inject new equity into that company, which if that does happen, would better position that asset for a better mark.

Yes. I was going to ask about Crown. That's a non-sponsored deal then Stuart?

No, that is a sponsor deal. And the sponsor adjusted equity previously several times, but the company does need more equity.

Yes, it looks like it from the mark on the second. Just a couple more questions, Stuart. The gain on the RCF shares, I didn't see them listed in the SOI for March. Were they held as a receivable of some sort on the balance sheet? Or was this just unexpected income that you booked below the line?

Mickey, it's going to be the latter. If you recall, the RCF shares were received in conjunction with the restructuring of the actual investment that we had in RCS, which had converted into equity in Arotech. This was proceeds received from the residual bankruptcy state of the oldco -- it was unexpected in nature. Our understanding is that this distribution would be the only distribution we would receive. We don't expect to have any further amounts in the future.

So there's no remaining receivable or anything like that on the balance sheet?

Correct. We don't have anything recorded.

Okay. And lastly, Stuart, we haven't asked them for a while. Can you just remind me where in the life cycle, the private funds at HIG that own WhiteHorse shares are? How many years left before they have to deal with that issue?

It's a great question, and I have not measured the passage of time, so I don't have an answer ready. Joyson, if you happen to know that would be great. And if not, we can try to get that data to you after the call and a follow-up, Mickey.

Just from your gut store, is it still multiple years away?

Oh, yes, years, years away.

Our next question will come from Melissa Wedel with JPMorgan.

I wanted to follow up on your commentary about the repayments that are coming in. It sounds like there -- if I heard you correctly, some repayments that are expected, but maybe were delayed or starting to materialize. But taken with your comments about wanting to run portfolio leverage at the higher end of your target range. Should we be thinking about the back half of this year as seeing a pickup in repayment activity but also expecting net deployment given the robustness of the pipeline?

Yes. The pipeline is quite robust. We have seen repayments, which have created about $50 million of investment capacity. We are expecting repayments in Q3 and Q4 and have a pipeline of deals that could refill our coffers. In the vast majority of cases, our expectation is that pricing will be higher, both on JV deals and balance sheet deals for the BDC than it was really for all of 2021 and the early part of 2022.

We are seeing pricing up anywhere from 50 to 200 basis points with the higher increases associated with the broadly syndicated market and/or with credits that have more cyclicality. We continue to take a very cautious view on companies that have cyclicality, and we'll do those only at modest leverage multiples with owners that are putting up big equity checks who we believe will support those companies if we do have a prolonged economic downturn.

But broadly, I would tell you what we are seeing in portfolio is better than we've seen in many years. During 2020, there was a brief period as I reported, where pricing and structure was very attractive. But during that part of 2020, really March to September, the markets were largely frozen and not a lot of deals got done. We did as many as we could, but there were that many done. Right now, seeing lower leverage, stronger deal terms, stronger covenants, and better pricing makes me feel like we're seeing an environment that is more aligned to like 2016 than any time since then.

So we think it's a very attractive time to invest, and we're pleased that we have some capacity in the BDC to invest. And our intention is that all the deals that go on the BDC balance sheet will go on with pricing of SOFR 700 or above. And most of those loans will continue to be first lien loans, although we will consider some second liens given that market is trading very weekly right now, and there may be some opportunities to add some higher-yielding assets.

That's really helpful. I appreciate all that context. It raised another question in my mind. Given some of the struggles that you're starting to see some portfolio companies have at least on the cost side and maybe a little bit on the top line as well. Is this an environment where you would think of skewing more towards sponsor deals and away from non-sponsor, just to have the potential backup equity capital and owner to set in and inject more capital as needed? And if so, what's the implication on yield of new investments? Appreciate it.

Our general perception, Melissa, is that in a hot market environment where sponsor-backed deals get premium leverage that our nonsponsor deals are actually less risky because they're levered on average, 1 turn or 1.5 turns lower and you get higher price and tighter docks and tighter covenants. In this market environment, where sponsor deals have become less risky because leverage multiples have come down and loan-to-values have come down. I would say that I see sponsor deals as being equally attractive to non-sponsor deals. And as a result, more of our deals that we're in pipeline right now and actively working on our sponsored transactions.

But I can tell you that for anything that we would deem to be stretched senior debt or unitranche debt, we're seeing minimum pricing of 650 and debt that was senior debt that would have been pricing at $4.75 to $5.25 before. We are now getting minimum pricing of 600. So again, the market is much more attractive in terms of asset quality. And these are typically non-cyclical borrowers. Cyclical borrowers trade at even higher price or higher yield. We see the market as extremely attractive right now, even as we're being cautious about an economic downturn for the balance of 2022 and into 2023.

(Operator Instructions) Our next question will come from Robert Dodd with Raymond James.

Kind of touching on to that pricing question again. I mean, you've been very clear about the expansion in spreads too. But there was -- I believe, the comment you made during your prepared remarks you said several lenders have not adapted to the new market. I mean is that an indication there are still a number of lenders don't know that are underpricing where you think the bulk of the market has moved today?

Can you give us any more color on that? I mean one line, I mean, the concern there would be, is that like-for-like? Are they picking off the higher-quality A+ deals or just underpricing where you think the market is? And is that potentially raising the prospect of spreads snapping back lower again?

Vicki, the thing that has -- sorry, Mickey -- Robert, I apologize for that. Robert, good to hear from you today. The thing that has really surprised us is that it has not been what you thought and what we would have thought would have been the case, which is that these lenders are cherry-picking the cleanest credits and then underpricing them to market to win the best credit deals.

There's one deal that we were doing that was a company that had $14 million of EBITDA that served the financial industry, and it served really the venture financial industry. That company definitely has a risk of cyclicality. And we took a view on leverage and price that was we thought responsible and someone underprice us by a wide margin on a transaction that was, we think, fully levered and had some -- not deep, but had some cyclicality risk.

Another deal that we let go was a company that had 2 large customer concentrations to brick-and-mortar retailers who are famous on being hard on their suppliers. We thought that, that was a major credit flaw, and it caused us to lower the leverage on the deal and even at the lower leverage command or ask for a higher price. And one of these lenders that we think have not adjusted to the market did higher leverage than us. So they took the risk of the concentrations and they did higher leverage and they did lower price. So for these few lenders, and we think it's only 3 to 5. I mean out of the 100 lenders in the market that we may compete with, we think it's only like 3 to 5 that haven't adjusted but they clearly have not adjusted.

I don't know why. I said it was surprising in my comments, and it is surprising. And I was on the phone with a large investment LP, someone who has a separately managed account with us, and they told us that other firms that they do business with have given them the same names of these institutions who appear to not be reacting to the market change. So they're not picking off the better credits. They're taking what we think is very high credit risk, and we're fine to lose deals where someone wants to be more aggressive on the leverage and lower on the price. We have a huge pipeline, Robert. And we can afford to lose a lot of deals and still have the BDC be fully invested in a very carefully selected portfolio of credits.

I appreciate the color there. Yes. And I'd rather I think by investors and for you stay away from those kind of deals. The next one here, I mean, as you said, right, there is a lag in the portfolio company financial data you get 45, 60 days, some 90 days in some cases. With the color that you gave on margin pressure, et cetera, et cetera, and that has lagged. I mean have you -- in the most recent data, are you seeing any shift in the rate of the curve or the rate of occurrences of margin pressure in the most recent data versus, say, the data that has a longer lag?

Robert, so the beauty of being in the mid-market and lower mid-market is we don't sit blind for 90 days post-quarter end, not really knowing what's going on with our credits. We regularly have dialogue with the owners of the company and the management teams of the company. And especially for companies that are under pressure, we will often seek to get updates either monthly or even weekly. What I can tell you we're seeing right now is most companies have been successful in passing through price increases. There is a slowdown in consumer demand, and that is impacting some number of the companies that were moved to a 3 in rating. But we're also seeing a slowdown in inflationary pressure.

We saw labor rates rising very rapidly for the entire last year, 1.5 years. But with labor rates, we have one company, I'll let it remain nameless. We have one company that had full employment of $13 an hour pre-COVID, and they had to raise rates to $18 an hour to get full employment now. But $18 an hour, they're at full employment. And we haven't seen that $18 an hour move over the last 3 or even really last 6 months. So we're seeing labor wage inflation slowdown. We're seeing container costs from Asia come down dramatically. They're down almost 50% so we think some of the inflationary pressures may have already passed, and we could see consistent with what got reported this morning, a slowdown in inflation. Now that said, we are still seeing some raw material price increases. We do have customers that are still pushing through price increases, but it's less now than it was 3 to 6 months ago.

(Operator Instructions) It appears we have no further questions at this time. I would now like to turn the program back to our presenters for any additional or closing remarks.

I'd like to say thank you to everyone for taking the time today. We're in an attractive but market condition that requires caution, but we are seeing good transactions, solid pricing, and we do hope to fully deploy the BDC capital and keep it generally between the 125 to 135 in leverage that we've outlined unless we take on a lot more second lien loans, which at the moment, we're not actively doing.

So positive trend line, and we'll continue to share with you as much information as we can. And for any of the analysts or shareholders that want to communicate with us intra-quarter, we're happy to answer questions. And for next quarter's call, please let us know anything you want us to include in the prepared remarks, and we'll try to do that. So thank you very much.

Thank you. Ladies and gentlemen, this concludes today's event. You may now disconnect.