WhiteHorse Finance, Inc. (NASDAQ:WHF) Q1 2023 Earnings Call Transcript

WhiteHorse Finance, Inc. (NASDAQ:WHF) Q1 2023 Earnings Call Transcript May 9, 2023

WhiteHorse Finance, Inc. beats earnings expectations. Reported EPS is $0.46, expectations were $0.43.

Operator: Good afternoon. My name is Shelby, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance First Quarter 2023 Earnings Conference Call. Our host 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 is 402-220-1548. No passcode is required. . It is now my pleasure to turn the floor over to Robert Brinberg of Rose & Company. Please go ahead.

Robert Brinberg: Thank you, Shelby, and thank you, everyone, for joining us today to discuss WhiteHorse Finance’s first quarter 2023 earnings results. Before we begin, I’d 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 can 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 WhiteHorse Finance’s first quarter 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.

Stuart Aronson: Thank you, Rob. Good afternoon, 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 for the period ending March 31, 2023, which can also be found on our website. On today’s call, I’ll begin by addressing our first quarter results and current market conditions. Joyson Thomas, our Chief Financial Officer, will then discuss our performance in greater detail, after which we will open the floor for questions. I’m pleased to report strong performance for the first quarter of 2023. In Q1, GAAP net investment income and core NII was $10.7 million or $0.461 per share, which more than covered our previously declared dividend of $0.355 per share.

Regarding dividends and as previewed on our last earnings call, the management and the Board of the BDC have closely examined whether an upward adjustment should be made to the regular dividend, given the improved earnings power of the BDC portfolio, resulting from an increase in spreads and base rates. In this regard, we are announcing several changes to our dividend structure to ensure that our shareholders benefit from our earnings momentum. I’m pleased to announce that our Board has elected to increase our regular quarterly dividend of $0.37 per share, up from $0.355 per share that we have paid consistently since our IPO. We believe that this increase in our regular dividend is both appropriate and sustainable given the increased earnings power of our portfolio.

In addition, to ensure our shareholders consistently benefit from the earnings generated in excess of this regular dividend, we are introducing a new formula-based supplemental dividend. The supplemental dividend will be calculated as 50% of our NII in excess of our regular dividend rounded to the nearest cent, and subject to certain measurement tests. Joyson will discuss the supplemental dividend framework in more detail later in the call and how that framework applies to our Q1 2023 financial results. NAV per share at the end of Q1 was $14.20, representing a $0.10 decrease from prior quarter, inclusive of the $0.07 per share special dividend that was declared in Q1. In addition to the impact of the special dividend, mark-to-market losses in our portfolio contributed to the decline in NAV per share.

These mark-to-market losses, which totaled $3.5 million, were driven by company-specific performance and some of our consumer-facing portfolio companies as well as some specific challenges, certain portfolio companies are experiencing independent of economic conditions. Turning to our portfolio activity for the quarter. Gross capital deployments in Q1 totaled $34.1 million. Of this amount, $18.8 million was funded into 3 new originations and the remaining $15.3 million funding add-ons to existing portfolio investments. In addition to these add-ons, we had $0.7 million in net fundings made under our existing revolver commitments. All 3 of our new originations in Q1 were sponsored deals and had an average leverage of approximately 3.6x. I note that all these deals were first-lien loans with spreads of 6.75% or higher and had an average all-in rate of 12%.

At the end of Q1, 96.8% of our debt portfolio was first-lien and 100% was senior secured. In Q1, total repayments and sales were $19.3 million, primarily driven by 1 complete realization and 2 partial paydowns. Additionally, during the quarter, the company transferred 3 new deals and 4 add-ons to the STRS JV totaling $25.9 million. Although originations continued to outpace repayments, the result of the JV transfer activity led the company’s net effective leverage to decrease slightly down to 1.23x from 1.26x at the end of Q4 and consistent with management’s long-term target range. Subsequent to quarter end, there has been 1 full realization to date. We are pleased to announce that the turnaround process of our formerly troubled asset, Arcole Holding has reached a profitable conclusion.

We, alongside 1 other lender, took control of the operating company and have successfully managed that company to a sale transaction. In April of this year, we exited our investment with an approximate 1.2x return on the original invested capital. This outcome demonstrates Whitehorse and H.I.G. Capital’s ability to leverage our collective resources and expertise to turn around troubled investments with the objective of minimizing losses and capital preservation. We anticipate repayment activity to remain relatively low through the first half of 2023. Given the change in marketplace pricing, which I’ll discuss shortly, we believe that repayments of historical investments, when they occur, will likely allow WhiteHorse to redeploy that capital into higher-yielding investments.

As I shared on prior calls, so long as our portfolio remains heavily concentrated in first-lien loans, which have a lower risk profile than second-lien loans, we expect to continue to run the BDC at up to 1.35x leverage. With that in mind, I’ll now 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 changes, the fair value of our investment portfolio was $749.2 million at the end of Q1. This is down marginally from $760.2 million at the end of Q4. The weighted average effective yield on our income-producing debt investments was 13.2% as of the end of Q1, an increase from the Q4 level of 12.6%. The variance was primarily driven by an increase in the portfolio’s base rate.

Addressing the STRS Ohio JV, we continue to successfully use the JV. The JV generated investment income to the BDC of approximately $4.2 million in Q1 as compared to $4 million in Q4. This increase was primarily driven by moderately higher base rates. As of March 31, the fair value of the JV’s portfolio was $308.9 million. And at the end of the Q1, the JV’s portfolio had an average unlevered yield of 11.8%. Comparatively, the average yield was 11.3% in Q4 and 7.86% in Q1 of 2022. The increase in unlevered yield is primarily due to the rising base rates. With the rise in base rates, the JV is currently producing an average annual return on equity in the mid-teens to the BDC, we believe WhiteHorse’s equity investment in the JV provides attractive return for shareholders.

Given the JV’s return on equity, we look forward to utilizing the recent new capital commitment as we seek to increase our exposure to a highly accretive earnings stream. Transitioning to the BDC’s portfolio more broadly. As mentioned earlier, there were some markdowns in the portfolio in Q1. I will elaborate on specific market dynamics shortly, but would note that as of the last quarter, we see credit pressure as most acute in consumer-facing companies. Nonetheless, the vast majority of our deals have strong covenant protection, and we are finding that private equity owners are behaving very well and supporting their credits with new cash or contingent equity as needed. Other than the consumer-facing borrowers and a couple of other credits, the vast majority of our portfolio is performing well.

Notably, our investment in American Crafts and Sklar Holdings underwent restructuring during the quarter as both companies have consumer exposure and have been experiencing demand softness. These deals were non-sponsor owned, and the owners did not have the liquidity to effectively manage the businesses through the downturn. As such, WhiteHorse elected to provide both companies with the necessary liquidity in return for control equity positions in each company. Alongside restructuring professionals at H.I.G. Capital and other private equity lender partners, we are working to strengthen the companies and manage through a weaker demand environment in order to position each company for a successful exit in the next 2 to 4 years. Additionally, as I previewed last quarter, our original remaining debt investment in PlayMonster was moved to non-accrual status at the beginning of Q1.

Photo by DocuSign on Unsplash

This is our only asset on non-accrual, and the deal represents less than 1% of the BDC’s portfolio at fair value. WhiteHorse took control of the company during Q1 of 2022 after financial irregularities were uncovered. In response to toy demand being lower than usual this past holiday season, the BDC and the other senior lender have provided additional defensive funding to PlayMonster in order to help the company move past the current consumer demand softness and provide a bridge to the holiday season in 2023. We anticipate the PlayMonster turnaround process will take 2 to 4 years, and there can be no assurances that we will ultimately recover 100% of our invested capital. Turning to broader lending market. As mentioned last quarter, the back half of 2022 saw a material correction in the direct lending markets as the combination of general economic weakness, significant inflation and rising interest rates applied credit pressure on borrowers.

While economic conditions in the first quarter of 2023 continue to test debt coverage, we remain happy with the performance and the quality of our portfolio companies. In general, we’ve observed an increase in borrower revenues, which can be attributed to inflation and about half our portfolio companies have been able to maintain margins by successfully passing through increased costs. In the other half, there’s been an uptick in leverage, which thus far has only had a modest impact on our typical borrowers’ debt service coverage. We remain vigilant in monitoring our portfolio of companies, and we have not seen the demand weakness in other sectors, including general industrial, B2B, health care, TMT and financial services. Additionally, our portfolio remains mostly represented by non-cyclical or light cyclical borrowers as we hold no direct exposure to oil and gas, auto or restaurants and very little exposure to the construction sector.

With the markets remaining disruptive by credit challenges, we have heard that several lenders are beginning to experience troubles in their portfolio, driven by highly leveraged loans that were closed in the quarters prior to the rising interest rate environment. Meanwhile, WhiteHorse has consistently and deliberately chosen to deploy capital into deals with more conservative leverage terms and with premium pricing, and as such, has built a portfolio that we believe is better equipped to withstand a potential economic downturn with high inflation. While there are still a few lenders that appear to be slow at adjusting to the new market realities, the average lender is now pursuing credits with lower leverage profiles and there continues to be less capital available in the marketplace than before the correction.

The banking community that services a syndicated market of loans has thus remained highly conservative. And from a lending perspective, in our opinion, the overall terms in the private debt market are as good now as they have been since the great Recession. In the mid-to-lower end of the market, which is our focus, loans are now being issued on more conservative credit terms with tighter documentation and covenants. And in addition to that, increased pricing. However, this pricing change is more pronounced in the mid-to-upper mid markets than in the lower mid-market. As we continue to focus on optimizing risk returns and navigate towards the market segments that offer the best rewards for investors during any period of time, the BDC has begun to divert more resources to the mid and upper mid market deals in order to take advantage of the most attractive risk-adjusted returns.

Despite the exceptionally attractive market terms, we are being cautious in the face of a weakening economy. Given our expectations for a weak economy in the balance of 2023 and 2024, we want to ensure that the companies we invest in can weather the storm. We are also increasingly focused on cash flow coverage and the risk that rates may continue to rise, although the forward curve indicates that rates will likely decline. The investments in our existing portfolio were underwritten at modest leverage levels and generally, we are well-positioned to withstand even another 100 basis points of rate increases. WhiteHorse is equipped to take advantage of these lender-friendly market conditions as our pipeline remains at seasonally strong levels despite the market disruptions and our 3-tier sourcing architecture continues to provide the BDC differentiated sourcing capabilities.

The overall pipeline is over 180 deals, and we continue to derive significant advantages from the shared resources and affiliation with HIG, who is a leader in the mid-market. The strength of the pipeline enables us to be conservative in our deal selection and the current primary limiting factor for originations is the BDC’s investing capacity. Our strategy and competitive advantages continue to result in momentum in our originators in originations business. Thus far in the second quarter, the company has closed on 2 new deals, one of which will be transferred to the JV as well as one add-on transaction that will also be transferred to the JV. We currently have visibility for several additional new deals, although there can be no assurance that any of these will close nor that the BDC will have capacity for these deals.

We anticipate utilizing the capacity provided by repayments when they occur to continue to rotate into higher-yielding assets. Additionally, we expect to see growth in the JV portfolio as we draw down on our newly increased commitment to the joint venture. Both of the aforementioned factors should ultimately lead to higher income and greater coverage for our dividend. At the conclusion of the first quarter, we remain cautiously optimistic. Despite expectations of economic softening, we believe WhiteHorse is well-positioned to continue executing on our 3-tiered sourcing approach with rigorous underwriting standards in the new year and beyond. With that, I’ll turn the call over to Joyson for additional performance details and a review of our portfolio composition.

Joyson, go ahead.

Joyson Thomas: Thanks, Stuart, and thank you all for joining today’s call. During the quarter, we recorded GAAP net investment income and core NII of $10.7 million or $0.461 per share. This compares with Q4 2022 GAAP NII and core NII of $11.1 million or $0.476 per share as well as our previously declared quarterly distribution of $0.355 per share. Q1 fee income decreased quarter-over-quarter to $1 million in Q1 to $1.9 million in Q4, with Q1 amounts being highlighted by amendment fees of $0.6 million generated from investments in Lift Brands, Lenny & Larry’s and Brooklyn Bedding. For the quarter, we reported a net increase in net assets from operations of $7.5 million, which is an $8.7 million increase from Q4 2022. Our risk ratings during the quarter show that 73.2% of our portfolio positions carried either 1 or 2 rating, slightly lower than the 74.8% reported in the prior quarter.

As a reminder, one 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 continue to grow our investment. As Stuart mentioned earlier, we transferred 3 new deals and 4 add-on transactions totaling $25.9 million in exchange for cash proceeds of $25.9 million. As of March 31, 2023, the JV’s portfolio held positions in 30 portfolio companies with an aggregate fair value of $308.9 million compared to 28 portfolio companies at a fair value of $284.3 million as of December 31, 2022. Subsequent to the end of the first quarter, the company transferred 2 investments to the JV, including 1 new portfolio company.

The investment in the JV continues to be accretive to the BDC’s earnings, generating a mid-teens return on equity. 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 $22.2 million at the end of Q1, including $10.5 million in restricted cash and approximately $97 million of undrawn capacity available under our revolving credit facility. We continue to monitor the ongoing situation impacting certain regional banks and do not expect any of our portfolio companies’ business operations to be significantly impacted as a result of these events.

That said, we maintain a vigilant posture and are prepared to support them. WhiteHorse Finance has sufficient liquidity to be the unfunded need of our portfolio of companies and broad resources to ensure continued support of our current portfolio companies against the highly volatile market backdrop. As of March 31, 2023, the company’s asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 177.1% 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 1.23x as compared to 1.26x in the prior quarter. Before I conclude and open up the call to questions, I’d like to again highlight our distributions. On March 2, 2023, we declared distribution for the quarter ended March 31, 2023, $0.355 per share to stockholders of record as of March 2024.

The dividend was paid on April 4, 2023, marking the company’s 42nd consecutive quarterly distribution. This speaks to both the consistent strength of the platform as well as our resilient deal sourcing capabilities and be able to create a well-balanced portfolio generating consistent current income. In addition to this quarterly distribution, we declared a special distribution of $0.07 per share for stockholder record as of March 24, 2023. The distribution was also paid on April 4 and inclusive of the special distribution. Total distributions paid thus far in 2023 amount to $0.425 per share. Finally, this morning, we announced that our Board declared an increase in our regular distribution. Specifically, our second quarter distribution will be $0.37 per share to be payable on July 5 to stockholders of record as of June 21, 2023.

This will mark the company’s 43rd consecutive quarterly distribution paid since our IPO in December 2012, with all distributions at or above $0.355 per share per quarter. Additionally, as Stuart mentioned before, each quarter, the Board will utilize a framework to determine if a supplemental distribution should be made. This formulaic quarterly supplemental distribution, if declared, will be in addition to the regular quarterly distribution that was just raised to $0.37 per share. The framework that Board will use to determine the supplemental distribution, if any, will be calculated as lesser of, one, 50% of the quarter’s earnings that is in excess of the quarterly based distribution; and two, an amount that results in no more than a $0.15 per share decline in NAV over the current quarter and preceding quarter.

Earnings for the purpose of measuring the excess over the quarter’s based distribution is net investment income. The NAV decline measurement is inclusive of the supplemental distribution calculated, and to be clear, is measured over the 2 most recently completed quarters. Accordingly, for Q1 2023, we had generated $0.461 per share of NII, which was in excess of our previously declared first quarter to regular distribution of $0.355 per share. The framework would then have us take 50% of this excess or $0.053 per share and rounded to the nearest cent, which would equate to a proposed $0.05 per share supplemental distribution. However, given our negative NAV per share movements during Q4 2022 and Q1 2023 as a result of unrealized mark-to-market declines in the portfolio, the $0.15 per share NAV decline limitation was a factor for the quarter’s calculation.

As such, our Board did not declare a supplemental distribution for this quarter. We believe this formulaic supplemental distribution framework allows us to maximize distribution to our shareholders while preserving the stability of our NAV, a factor that we do believe to be an important driver of shareholder economics over time. With that, I’ll now turn the call back over to the operator for your questions.

See also 20 Most Common IRS Audit Red Flags and 15 Best Countries for Cancer Treatment.

Q&A Session

Operator: . We’ll take our first question from Mickey Schleien with Ladenburg.

Mickey Schleien: Stuart and Joyson, can you hear me?

Stuart Aronson: Yes, Mickey.

Mickey Schleien: I just wanted to follow-up on your comments about the level of competition to make sure I understand what you were saying because we’re hearing that larger commercial banks are constraining their lending, and there are obviously challenges for some lenders to access the syndicated loan market. So how do those trends play into your strategy of going upmarket within the BDC and also the opportunity in the senior loan fund?

Stuart Aronson: Exactly as you said, because the syndicated markets are still in disarray for all, but the strongest to borrowers. There’s more opportunity in the markets served by direct lenders and BDCs and those deals are increasingly attractive as you get to companies with EBITDA that is in the mid-market range of $30 million to $100 million. So whereas we’ve seen on average lower spreads on smaller deals, which is the opposite of a normal upmarket environment. Mickey, in a normal market, our lower mid-market off-the-run sponsor deals have spreads that are typically 50 to 75 basis points higher than mid-market and upper mid-market deals. And at the moment, the spreads are either aligned or the lower mid-market deals are 25 basis points lower.

So from a risk return perspective, we believe that the mid-market and upper mid-market at this moment is generally not on every deal, but generally more attractive. And we’ve been booking deals that are generally larger EBITDA companies with $30 million of EBITDA or more.

Mickey Schleien: Stuart, if I can follow-up. I mean you’re absolutely right. I mean I can’t recall a situation where spreads in upper middle market or middle market are better than lower middle market. Is that being caused by some players that are acting irrationally or new entrants or is it some specific deals that are getting done at numbers that aren’t attractive to you? But that’s a really unusual situation. Is there anything you can tell us about what precipitated that?

Stuart Aronson: There are a couple of lenders in the lower mid-market marketplace who continue to underprice deals versus the mid-market. When we see that happen, we just let those deals go, and we reallocate our resources into the more attractive risk-return transactions. There was more of that going on in 2022. There were more lenders who had not adjusted to the market price. But we’re not concerned by it. We just think the market dynamics are abnormal right now, and we do expect over time that the lower mid-market deals will once again command a premium to the mid-market deals. It’s just with the shortage of liquidity in the mid-market, those mid-market deals are being priced up to find adequate liquidity.

Operator: And we’ll take our next question from Robert Dodd with Raymond James.

Robert Dodd: Congratulations on the quarter and the variable — supplemental formulaic dividend that Essentially following up to Mickey’s, on this mid-upper versus lower, are you seeing, I mean, obviously the 3 deals, you did with were sponsored transactions. And typically, as we move further up market, I think that’s less and less non-sponsored. So is this going to result in a further mix shift away from non-sponsored transactions in the portfolio? And is that part of the deliberate calculus or that just a side-effect of where you’re seeing the risk return in the upper market right now?