WhiteHorse Finance, Inc. (NASDAQ:WHF) Q2 2024 Earnings Call Transcript

WhiteHorse Finance, Inc. (NASDAQ:WHF) Q2 2024 Earnings Call Transcript August 8, 2024

WhiteHorse Finance, Inc. misses on earnings expectations. Reported EPS is $0.4113 EPS, expectations were $0.45.

Operator: Good morning. My name is Jamie, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Second Quarter 2024 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) 220-5395, no passcode is required. At this time, all participants have been placed in a listen-only mode and the floor will be open for your questions following the presentation. [Operator Instructions] It is now my pleasure to turn the floor over to Robert Brinberg of Rose & Company. Please go ahead.

Robert Brinberg: Thank you, operator, and thank you, everyone for joining us today to discuss WhiteHorse Finance’s second quarter 2024 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 2024 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.

Stuart Aronson: Thank you, Rob, and good morning, everyone. Thank you for joining us today. As you’re aware, we issued our earnings this morning prior to market open, and I hope you’ve had a chance to review our results for the period ending June 30, 2024, which can also be found on our website. On today’s call, I’ll begin by addressing our second 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. Our results for the second quarter of 2024 were a bit softer due to elevated repayment activity and some markdowns on our portfolio. Q2 GAAP net investment income and core NII was $9.3 million, or $0.40 per share, exceeding our quarterly base dividend of $0.385 per share.

This represents a decrease from Q1 GAAP and core NII of $10.8 million and $0.465 per share. NAV per share at the end of Q2 was $13.45, representing a 0.4% decrease from prior quarter. NAV per share was impacted by net markdowns in our portfolio, totaling $1.5 million, the majority of which related to Honors Holdings, which I will discuss shortly. Turning to our portfolio activity in Q2, we had gross capital deployments of $55.8 million, which was more than offset by total repayments and sales of $71.7 million, resulting in net repayments of $16.1 million. Gross capital deployments consisted of seven new originations totaling $47.4 million, with the remaining $8.4 million used to fund nine add-ons to existing investments. Our seven new originations in Q2, three were non-sponsor and four were sponsor deals with an average leverage of approximately 3.8x debt-to-EBITDA.

Q&A Session

Some of these new assets were transferred to the JV during the quarter and for the deals that stayed on the BDC. On the BDC balance sheet, leverage was around 3.6x. All of our Q2 deals were first lien loans with an average spread of 650 basis points and an average all-in rate of 11.8%. I note that both these statistics are attractive from historical and current market perspective. During the quarter, the BDC transferred four new deals and four add-ons to the Ohio STRS JV, totaling $22 million, in exchange for $22 million in cash. At the end of Q2, the STRS JV’s total portfolio comprised 38 issuers with an aggregate fair value of $324.8 million and leverage as of Q2 was 1.08x compared with 0.99x at the end of the prior quarter. At the end of Q2 99% of our debt portfolio was first lien senior secured and our portfolio mix was approximately 60% sponsored deals and approximately 40% non-sponsored deals roughly similar with prior quarter.

In Q2, total repayments and sales were $71.7 million, primarily driven by four complete realizations and one partial realization. Repayments are elevated for two reasons. There are a series of counts where performance was challenged and we asked the borrowers to refinance us out in this borrower-friendly market and they’ve done that. This amounted to roughly 80% of our repayments in Q2. We don’t expect to see many more refinancings in this category. There may be a couple of credits that we want to exit though. And then there are some other accounts with a much lower interest rate environment, and the more aggressive credit environment has led borrowers to be able to push up leverage and push down price. On some of those deals we’ve just felt the resulting transactions are too aggressive and we’re letting these go.

We expect that the borrower-friendly market combined with eventually declining base rates will likely lead to a continued flow of refinancings into the latter part of the year, especially as call protection on the deal steps down or expires. We expect refinancings to remain heavy through the balance of the year. Thus far in Q3, there have been no full repayments or sales, though. With that in mind, I’ll now step back to bring our entire investment portfolio into focus. After the effects of net repayments and the STRS JV transfers as well as $1.5 million in net mark-to-market decreases, $0.2 million of realized losses and $0.8 million of accretion, the fair value of our investment portfolio was $660 million at the end of Q2. This compares to our portfolio’s fair value of $697.9 million at the end of the previous quarter.

The weighted average effective yield on our income producing debt investments was 13.8% at the end of Q2, a 40 basis point improvement compared to 13.4% in the second quarter of 2023, and up slightly from 13.7% in the first quarter of 2024. We continue to utilize the STRS JV successfully. The JV generated investment income to the BDC of approximately $3.9 million in Q2, compared to $4.8 million in Q1. As of June 30, the fair value of the JV’s portfolio was $324.8 million and the portfolio had an average unlevered yield of 12.3% compared to 12.4% in Q1. 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 returns for our shareholders.

Traditionally transitioning to the BDC’s portfolio more broadly, there were some markdowns in the portfolio during Q2. Most notably, there was a $2.2 million markdown to our investment in Honors Holdings, which was placed on non-accrual status in the middle of the quarter, resulting in a decrease of approximately $125,000 of interest compared to expectations at the start of the quarter. Honors was a company that was heavily impacted by COVID. After that, a private equity firm contributed additional equity Honors to help them navigate the pandemic and to further execute on its growth strategy in the face of a weak market. However, the company has been experiencing weaker customer trends in recent quarters. Now we’re taking action to position the company for remediation and we’re working with both the franchisor and of the concept who currently – and the current owners of the company.

We expect to improve and resolve that investment over the next 12 to 24 months. Honors meaningfully contributed to the increase in non-accrual investments, which totaled 4.2% of the total debt portfolio at fair value, compared with 1.3% at Q1 excluding investments in the STRS JV. In regard to American Crafts and Arcserve, we continue to execute turnaround plans to maximize the value of both of these companies, working alongside our restructuring resources and private equity resources, and we remain optimistic that we would seek exits on those in 18 to 30 months. We otherwise see balanced activity in terms of credit performance across the portfolio generally and remain overall pleased with the health and relative stability of our debt portfolio with cash flow coverages holding up in a high interest rate environment.

Turning to the broader lending market, there continues to be a supply demand imbalance in favor of borrowers. As a result, market conditions across all of the sponsor segments remain very aggressive. In the upper mid cap and large cap markets, we’re seeing leverage of anywhere between 5x to 7.5x. We also see lenders putting pick leverage on companies for an additional 1 to 2 turns beyond that 5x to 7.5x. Picked leverage occurs in the market from time to time, but we are generally avoiding it. Pricing in the upper mid cap and large cap markets is SOFR 450 to SOFR 500, with an original issue discount of between 98 and 99. We have been avoiding doing any deals in the upper mid cap and large cap markets due to the aggressive natures of these deals.

The mid-market is one step less aggressive. We are seeing leverage typically between 4.5x and 6x. Pricing in the mid-market is SOFR 500 to SOFR 550 for the most part with OID also between 98 to 99. The lower mid cap market is again one step less aggressive, with debt leverage generally running 4x to 5x and pricing in the lower mid cap market ranging from SOFR 500 to SOFR 600 with an OID typically of 98 to 98.5. The non-sponsor market has not moved much at all, with leverage remaining at 2.5x to 4.5x and pricing in the range is 600 to 800 over SOFR with an OID of 98 or lower. Given the relative attractiveness of the non-sponsor market, we are focusing heavily on originating deals in the non-sponsor sector. We are seeing more evidence of competitors accepting heavily adjusted EBITDA as they are trying to win new volume in a market that is short of assets.

We’ve seen bankers bringing out many refinancings on troubled credits where they’re trying to adjust the capital structure, often on highly adjusted EBITDA. Many of those deals that have come in front of us we think are negative cash flow deals. We don’t believe many of the adjustments and we think the leverage is too heavy and we’re turning down all of those deals. In the current market environment, we’re taking a cautious stance and focused on transactions that have positive free cash flow, limited cyclicality and strong owners behind them. The on the run sponsor market is clearly more aggressive than the off the run sponsor market and also more aggressive than the non-sponsor market. As a result, we are spending most of our time focused on the off the run sponsor market and the non-sponsor market.

With respect to the broader economy, we are seeing signs of weakening, that is showing up in lower consumer demand and in some sectors lower demand in the business to business segment. Given the gradual slowdown in the economy, we do believe that the Fed will begin to reduce interest rates in the fourth quarter of 2024. Following net repayment activity in Q2, the BDC balance sheet is approximately $60 million in capacity for new assets. The JV has approximately $30 million of capacity, supplementing the BDC’s existing capacity. Deals that are priced at SOFR plus 600 and above will generally put on the BDC’s balance sheet and deals priced below this level will generally go into the STRS joint venture. While volume is lighter than we’d expect it to be in all market segments, we’re actively working on six new mandated deals split evenly between sponsor and non-sponsor.

While there can be no assurance that any of these deals will close, all of these mandates would fit into the BDC or our JV should be elected transact. Subsequent to quarter end, we have closed three new originations totaling approximately $18 million, with several more pending. Of the new originations, two are expected to be transferred to the JV during the third quarter. So far, there have been no asset transfers to the JV in the third quarter. Our pipeline is still running about 180 deals, but the portion of the pipeline that we call active pipeline is lower than it would normally be this time of year. In addition, our three tier sourcing architecture continues to provide the BDC with differentiated capabilities. We derive significant advantages from the shared resources and affiliation with HIG, who is a leader in the mid-market and lower mid-market.

Whitehorse has approximately 23 origination professionals located in 11 regional markets across North America. The strength of this originations pipeline enables us to be conservative in our deal selection. Based on current market terms and conditions, we are taking a very cautious stance and focused on doing deals that have positive free cash flow, limited cyclicality and strong owners. Despite continued concerns regarding economic softening, we believe we are well positioned to continue to source attractive opportunities and navigate economic challenges to our strong originations capabilities and rigorous underwriting standards. With that, I’ll turn the call over to Joyson for additional details and a review of our portfolio composition.

Joyson?

Joyson Thomas: Thanks Stuart and thanks everyone for joining today’s call. During the quarter, we recorded GAAP net investment income and core NII of $9.3 million or $0.40 per share. This compares with Q1 GAAP NII and core NII of $10.8 million or $0.465 per share, and our previously declared quarterly distribution of $0.385 per share. Q2 fee income was lower quarter-over-quarter at $0.4 million compared with $0.6 million from the prior quarter. Q2 amounts were primarily comprised of approximately $0.3 million of amendment fees. For the quarter, we reported a net increase in net assets resulting from operations of $7.8 million. Our risk ratings during the quarter showed that 74.4% of our portfolio positions carried either a one or two rating, slightly lower than the 76.6% reported in the prior quarter.

As a reminder, a one rating indicates that a company has seen its risk of loss reduced relative to such initial expectations and a two rating indicates a company is performing according to such initial expectations. Regarding the JV specifically, we continue to grow our investment. As Stuart mentioned earlier, in the second quarter we transferred four new deals and four add-ons to the STRS JV totaling $22 million in exchange for cash proceeds of the same amount. As of June 30, 2024, the JV’s portfolio helped position the 38 portfolio companies with an aggregate fair value of $324.8 million compared to 34 portfolio companies at a fair value of $309.4 million as of March 31, 2024. The investment in the JV continues to be accretive to the BDC’s earnings generated a mid-teens return on equity.

During Q2 income recognized from our JV investment aggregated to $3.9 million during the quarter as compared with approximately $4.8 million in Q1. As a reminder and as reported in the prior call, in Q1, there was an elevated amount of income recognized from a JV investment largely attributable to non-occurring events that had occurred in the JV’s portfolio during Q1. As we have noted in the 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 $21.8 million at the end of Q2, including $8.9 million of restricted cash and approximately $167 million of undrawn capacity available under a revolving credit facility.

As of June 30, 2024, the company’s asset coverage ratio for borrowed amounts, as defined by the 1940 Act was 186.2%, 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 1.09x, compared with 1.19x from the prior quarter. Before I conclude and open up the call to questions, I’d again like to highlight our distributions. This morning we announced that our Board declared a third quarter distribution of $0.385 per share, which is consistent with the prior quarter. The upcoming distribution, the 48th consecutive quarterly distribution paid since our IPO in December 2012, with all distributions at or above a rate of $0.355 per share per quarter will be payable on October 2, 2024 to stockholders record as of September 18, 2024.

As we said previously, we will continue to evaluate a 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 over to the operator. Operator?

Operator: [Operator Instructions] We’ll go first with Bryce Rowe from B. Riley. Please go ahead.

Bryce Rowe: Thanks so much. Good morning.

Stuart Aronson: Good morning, Bryce.

Bryce Rowe: Hey Stuart, I really appreciate some of the market commentary and your cautious approach. I think it’s probably the more – one of the more cautious kind of messages that I’ve heard throughout the earnings season. Wanted to ask kind of about the flows in and out of the BDC from an investment perspective, leverage is coming down. It sounds like that cautious approach could lead to a more kind of muted activity as we think about the second half of this year and into next. Can you talk about kind of where you’re comfortable with leverage in terms of how low leverage could go on the balance sheet? Do you think you can maintain here or good chance that it continues to move lower?

Stuart Aronson: Bryce we’re lucky to have a HIG supplement origination capability that when the on the run markets get really aggressive like they are right now, we can squirrel down into the off the run markets and non-sponsor markets and find deals that we feel are a better risk return. When the markets were very favorable, we completely filled up the BDC and for a period of time the BDC had no capacity and we were doing deals that couldn’t go into the BDC. As I highlighted, we now have about $60 million of availability on the BDC balance sheet, which, given the average allocation, would be about six deals of incremental capacity plus an incremental two to three deals in the JV. Q3 is a decent but relatively slow quarter so far.

But in general, we tend to see Q4 as a stronger quarter. And even in a very slow M&A year like 2023, Q4 had volume that was about double what Q3 was. So I don’t expect that we’re going to use up the unused capacity in Q3. But we are hopeful that we will put most of the unused capacity to work in Q4 if we see a normal upswing in economic activity with the expectation of interest rate cuts in Q4, and many private equity firms being pressured by LPs to have realizations, and bankers telling us that their pipelines are reasonably robust. We’re hoping that after the August slowdown in September, October, we’ll see robust M&A flow and be able to use up some of that capacity.

Bryce Rowe: Okay, that’s helpful. And then in terms of kind of repayments, appreciate the commentary around repayment activity in the quarter. Can you help us kind of handicap if there are more portfolio companies in that “leave category or ask to leave category”? And then maybe on the flip side, help us understand or maybe handicap that other category you mentioned of companies coming to refinance and you all don’t want to participate because the terms are not up to your standards?

Stuart Aronson: Yes, in general, at the moment there’s only one company I can think of that I would put in the desired exit category. And so that category is going to slow down because I think we had three of them in the last quarter where we had the opportunity to stay with the credits, but we wanted to exit because of performance issues that our credit teams felt warranted a termination of the relationship. As it regards to the refinancings in 2022 and 2023, we were adamant about getting strong call protection, and we got call protection on our deals. That was generally two years on the sponsor deals and three to four years on the non-sponsor deals. To the extent that that call protection is starting to roll off, especially on the 2022 deals, we are seeing people come back and look to do refinancings.

In many cases based on the strength of the market those refinancings include dividends as well. And so where borrowers are taking up leverage, taking down equity in the company and taking down price, we’re only sticking with the stronger non-cyclical borrowers. And there are several transactions that have gone on where we just felt that the underlying leverage and price made it imprudent to stick with the borrowers. There’s no way to know how much of that we will see in the balance of Q3 and Q4. But there’s no doubt in my mind with interest rate or interest spreads as low as they are right now, that there will be continued refinancing pressure. If the credits are okay, we will adjust the pricing on those deals to the current market, which in many cases will take pricing from 600 to 650 down to pricing of 500 to 550.

But the thing that will make us exit is if the performance of the borrower combined with the leverage that they’re trying to put on the borrower leaves us questioning the stability of that credit in the ongoing period, especially because we have a view that the economy really is softening. We’re not necessarily predicting a recession, but we are predicting into 2025 a weaker economy, and we think it’s imprudent to overly leverage companies into a weaker economy, and we’re making our decisions on that basis.

Bryce Rowe: Good. Good stuff.

Joyson Thomas: Not recognizing Q2, it wasn’t necessarily a reversal of an accrual from the prior quarter. But when we put the Honors Holding position on non-accrual in Q2, essentially we didn’t recognize an additional $125,000 that we would have as compared to Q1.

Bryce Rowe: Okay. And then do you have a UTI balance or estimate for us?

Joyson Thomas: I don’t have the UTI balance handy for me right now. Let me see if I can just pull that up. I think it’s about $32 million, actually I just pull that – $32 million?

Bryce Rowe: Okay, awesome. Thank you, guys.

Operator: [Operator Instructions] We’ll go next to Sean-Paul Adams with Raymond James. Please go ahead.

Sean-Paul Adams: Yes, good morning. On the portfolio risk…

Stuart Aronson: Good morning.

Sean-Paul Adams: Good morning. On the portfolio risk ratings, it seems like the uptick in risk ratings four and five was likely due to the new non-accrual. Am I correct in that?

Joyson Thomas: Yes, I believe that is the case.

Sean-Paul Adams: Okay. So, but in aggregate, over the last six months, there has been a somewhat large shift in ratings just downward within the portfolio, at the beginning of January, risk ratings one were somewhere around 18%. Now they’re sitting around 12.8%. So it just seems like there’s a somewhat large waterfall effect going downward within the portfolio. And it looks like you guys are really paying large attention to the new deals on the market and really focusing on credit quality and leverage. What kind of aspects are you guys thinking about in regards to your existing portfolio companies? And is there any isolated sectors that are really experiencing the largest material weaknesses?

Stuart Aronson: Yes, Sean-Paul, in regard to the ones, what generally happens with credits that are overperforming is the companies get sold or the companies get refinanced. So there’s a natural effect that ones tend to go away and that happens in all market, but especially true in a strong market environment. That said, as I indicated in my prepared statements, we are seeing a slowdown in the economy, as recently has been indicated by data that’s been released into the marketplace and has led to some equity gyrations recently. We are spending a significant amount of time focused on existing portfolio. Most of our existing portfolio accounts are comfortably paying their interest burden and their debt burden. But we do have a number of situations that are not related to the general economy, like Honors Holdings, where it is a company specific issue that has led to the weakness in the performance.

And actually it’s a fairly recent issue as well. The company was only levered about 3.5x about a year ago, and the company has experienced weakness over the past 12 months. We have a five person restructuring team that gets involved in all the deals that need covenant waivers, and that restructuring team includes private equity professional who on owned accounts helps us put the right management teams in place, helps us come up with growth strategies for the company and helps us cut costs. And on Arcserve and American Crafts in particular, which are both owned assets, we are working with that restructuring team and with our private equity expertise to execute turnarounds that we hope will take hold and allow us to get strong exits in 18 to 30 months.

So there is a lot of attention being paid to portfolio. And in today’s market, where we think competitors are being overly aggressive, we are committed to trying to not add any marginal credit to our portfolio.

Sean-Paul Adams: Okay, thank you so much. And I believe you remarked earlier in the call that Honors Holdings probably had a timeline of 12 to 24 months of resolution process. And Honors – I believe you also mentioned Arcserve would probably be around an 18 to 30 month timeline as well?

Stuart Aronson: Yes.

Sean-Paul Adams: Okay. Okay. That’s perfect. I just needed to clarify that. Thank you so much for the color.

Stuart Aronson: No problem. Thank you.

Operator: And ladies and gentlemen, as there are no further questions in queue at this time, that will conclude our question-and-answer session and the WhiteHorse Finance second quarter 2024 earnings call. Thank you for your participation. You may disconnect your line at this time and have a wonderful day.

Stuart Aronson: Thank you. Bye-bye.