WhiteHorse Finance, Inc. (NASDAQ:WHF) Q4 2022 Earnings Call Transcript

WhiteHorse Finance, Inc. (NASDAQ:WHF) Q4 2022 Earnings Call Transcript March 2, 2023

Operator: Good afternoon, everyone. My name is Todd, and I will be your conference operator today. At this time, I would like to welcome everyone to the WhiteHorse Finance Fourth Quarter and Full Year 2022 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 pm Eastern Time. The replay dial-in number is 402-220-6071. No passcode is required. At this time, all participants have been placed in a listen-only mode, and the floor will be opened for your questions following the presentation. It is now my pleasure to turn the floor over to Jacob Moeller of Rose & Company.

Jacob Moeller: Thank you, operator, and thank you everyone for joining us today to discuss WhiteHorse Finance’s fourth 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 fourth 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.

Stuart Aronson: Thank you, Jacob. Good afternoon and thank you all for joining us today. As you are 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 ended December 31, 2022, which can also be found on our website. On today’s call, I’ll begin by addressing our fourth quarter and full year 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. This afternoon, we are pleased to report strong results for the fourth quarter and for the full year 2022. In 2022, core net interest income totaled $35.5 million or $1.526 per share, representing a 19% increase from 2021’s core NII of $29.7 million or $1.405 per share.

Full year core NII exceeded regular shareholder distributions by $0.106 per share, or $2.5 million. These results demonstrate the continued strength of WhiteHorse’s lending platform and strong origination activity highlighted by $221 million in gross deployments for the year. In Q4, GAAP net investment income in core NII was $11.1 million or $0.476 per share, which more than covered our quarterly dividend of $0.355 per share. This marked our highest quarterly NII since the Company’s IPO. Assuming no unforeseen factors emerge, as long as base rates continue to be in excess of 4% we expect the earnings power of the BDC’s current portfolio to exceed our current dividend level. NAV per share at the end of Q4 was $14.30, representing a $0.46 decrease from the prior quarter after accounting for the $0.05 per share special dividend that was paid in Q4.

This decline was largely the result of market pricing during the quarter that led to WhiteHorse’s marking performing assets, primarily due to valuation factors. Two of our portfolio companies were marked down due to performance as I will discuss shortly. Turning to our portfolio activity for the quarter, gross capital deployments in Q4 totaled $49.8 million, of this amount $42.1 million was funded into six new originations and the remaining $7.7 million was funded into six additional-ons to existing portfolio accounts. In addition to the add-ons, there was $4 million in net fundings made for revolver commitments. Of our six new originations in Q4, three were sponsored deals and three were non-sponsored deals, with an average leverage of approximately four times.

I note that all these deals were firstly in loans and had an average expected all-in rate of 12% and an effective yield of almost 13%, which was higher than the Q3 portfolio average. At the end of Q4 96.8% of our portfolio was first lien, and 100% of our debt portfolio was senior secured. During Q4 total repayments and sales for $40.7 million, primarily driven by three complete realizations. These largely offset the BDCs originations activity, leading to net deployments of $13.1 million for the quarter. In addition, one deal was transferred to the STRS Ohio JV in exchange for $8 million of cash. With origination slightly outpacing repayments, net effective leverage increased to 1.26 times at the end of Q4, as compared to 1.22 times at the end of Q3.

At this leverage level, we remain at the low end of our target leverage range of 1.25 to 1.35 times. As I shared on prior calls, so long as our portfolio remains heavily concentrated in first lien loans, which have lower risk than second lien loans, we expect to continue to run the BDC at up to 1.35 times leverage. Regarding the three complete realizations, we earned $2.6 million from interest and prepayment fees, and $1.6 million realized gain on the sale of warrants, which generated an aggregate IRR of 18.8% on the $38.1 million of aggregate capital invested in these deals. This attractive return for senior secured loans demonstrates the power of our sourcing model in the lower and mid markets. Fourth quarter realizations included Escalon Services, CHS Therapy, and Access USA Shipping.

In the first quarter, there’s only been one full realization to date, and we anticipate repayment activity to remain relatively low through the first half of 2023. Given the change in marketplace pricing, which I will discuss shortly, we believe that repayments of historical investments will likely allow WhiteHorse to redeploy that capital into higher yielding investments. With that in mind, I’ll now step back to bring our entire investment portfolio into focus. After $13.3 million in net mark-to-market decreases, $1.6 million in realized gains, $1.6 million of accretion and the effects of the STRS JV asset transfers, the fair value of our investment portfolio was $760.2 million at the end of Q4. This is down marginally from $764.6 million at the end of Q3.

The weighted average effective yield on our debt investments was 12.6% as of the end of Q4, which reflects an increase from Q3 level of 11.4%. The increase was primarily driven by a rise in the portfolio’s base rate. Addressing the STRS Ohio joint venture, we continue to utilize our JV successfully. The JV generated investment income to the BDC of approximately $4 million in Q4, as compared with $3.8 million in Q3. This increase was driven by modestly higher interest and dividend income from the JV in Q4. During the quarter, the Company transferred one new deal Max Solutions Inc. into the STRS JV. As of December 31st, the fair market value of the JV’s portfolio was $284.3 million. And at the end of Q4, the JV’s portfolio had an average unlevered yield of 11.3%, above Q3’s average yield of 10.1%.

The increase on unlevered yield is primarily due to rising base rates. Additionally, as announced on February 6th, we together with STRS Ohio, have increased our capital commitments to the JV by $25 million. The increased commitment comprised of an incremental 15 million investment from WhiteHorse Finance, and an incremental $10 million investment from STRS Ohio brings total capital commitments to the JV to $175 million. The JV produces average annual return on equity in the low to mid teens to the BDC. We believe WhiteHorse’ equity investments in the JV provides attractive return for shareholders. Given the JV’s return on equity, we look forward to utilizing the new capital commitment as we seek to increase our exposure to highly accretive and conservative earning streams.

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Transitioning to the BDC’s portfolio more broadly, as mentioned earlier, there are some markdowns in the portfolio as a result of the continued broad market price increases in Q4. I will elaborate on specific market dynamics shortly but would note that we see credit pressures as most acute in consumer facing companies. This is partly because many retailers overstocked inventory during the worst of the supply chain disruptions, and are now seeking to reduce those inventory levels materially. 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 consumer facing borrowers, the majority of our portfolio is performing well.

Notably, our investments in PlayMonster Inc. was marked down $2.7 million during the quarter and remains a troubled asset. Our team is working hand in hand with experts in private equity as well as external advisors to turn the Company around for sale. And we anticipate that process will take two to three years. Given new information since quarter end, we expect to move the original senior debt for PlayMonster to nonaccrual status beginning in Q1. It is worth noting, however, that even we PlayMonster on nonaccrual, less than 1% of the BDC’s portfolio at fair value would be on nonaccrual status. In the second half of 2022, the general direct lending markets experienced to material correction stemming from a combination of economic weakness, significant inflation and rising interest rates.

Despite these pressures, we are comfortable with the performance and quality of our borrowers. In general, we have observed an increase in borrower revenues, which can be attributed in part to inflationary pressures and higher prices. In about half our portfolio, companies have been able to maintain margins and successfully pass through increased costs with price increases, in the other half there’s been an uptick in leverage but thus far, this has only had a modest impact on our typical borrowers debt service coverage. While the portfolio is holding up well, we are keeping a careful eye on demand characteristics, especially in the consumer sector. Although our exposure to consumer facing companies represents less than 15% of our portfolio based on fair value.

In most of our consumer facing accounts, we’ve seen evidence of demand weakness. However, this has not appeared in other areas, including general industrial, B2B, healthcare, TMT and financial services, which have all been surprisingly strong. Additionally, our portfolio remains mostly represented by noncyclical or light cyclical borrowers, as we hold no direct exposure to oil and gas, auto or restaurants and a very small exposure in the construction sector. While many borrowers have been dealing with inflationary pressures, in our portfolio, those pressures appear to be moderating, evidenced by lower transportation costs and stabilization of labor costs. Regarding rising interest rates, we’ve always underwritten deals with the expectation that interest rates are going to rise, and we have avoided deals with excessive leverage.

During much of 2022, a number of lower mid-market lenders failed to adjust to the move in the broader market and continue to do deals on aggressive terms and surprisingly low price. Through the fourth quarter, we saw these players finally correct to the market. However, we understand that many lenders who underwrote at 6 times or more leverage are now having issues with their portfolio company’s ability to service debt. Meanwhile, WhiteHorse has consistently and deliberately chosen to deploy capital into deals with more conservative terms and with premium pricing, and as such has built a portfolio that we believe is better equipped than many to withstand a potential economic downturn. The credit market is largely reset to levels one would expect to see in the downturn, deals for cyclical companies are no longer being underwritten at aggressive leverage levels, and pricing even for non-cyclical assets have seen an upward adjustment.

In the mid to lower end of the market, which is our main focus, loans are now being issued on more conservative credit terms with tighter documentation and covenants in addition to increasing prices. From a lending perspective, the current market environment offers exceptionally attractive terms. Nonetheless, we are being cautious in the face of a weakening economy and remain focused on credits with compelling risk return characteristics. Our base case assumption is that we will see recessionary conditions in upcoming years. And we want to ensure that the companies we invest in can weather that storm. The investments in our existing portfolio were underwritten at modest leverage levels, and generally 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 activity levels remain high. And our 3-tier sourcing architecture continues to provide the BDC differentiated capabilities. The overall pipeline is over 150 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 origination is the BDC’s investing capacity. Our strategy and competitive advantages continue to result in momentum in our origination business. Thus far in the first quarter, the Company has closed three new deals, two of which will be transferred to the JV, as well as four add-on transactions.

We currently have visibility for several additional new deals. Although there can be no assurance that any of these deals will close, nor that the BDC will have capacity to fund any of these deals. We anticipate utilizing the capacity provided by repayments to continue to rotate into higher yielding assets. That combined with portfolio growth and the potential for increasing our investment in the JV should ultimately lead to higher income and greater coverage for our dividend. Regarding dividends and as announced this morning, in addition to our normal quarterly distribution of $0.355 per share, our Board has declared a special distribution of $0.07 per share for the quarter ended December 31, 2022. We will continue to assess future special distributions based on the Company’s earnings levels and the interest rate environment.

The management and Board of the BDC will also examine the ongoing improved earning power of the BDC portfolio, given increases in spreads and base rates to assess whether there should be an increase in the core dividend from $0.355 per share. I should have more detail to share on this topic by the next earnings call. As we start the New Year we remain cautiously optimistic. Despite expectations of economic softening, we believe WhiteHorse is well positioned to continue executing on our 3-tiered sourcing approach and 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 everyone for joining today’s call. During the quarter, we recorded GAAP net investment income in core NII of $11.1 million or $0.0476 per share, compared with the quarterly distribution of $0.355 per share. In Q3 GAAP NII was $9.8 million or $0.42 per share. And core NII was $8.6 million or $0.372 per share. Q4 fee income increased quarter-over-quarter, up to $1.9 million from $0.4 million in Q3. And it was driven by prepayment fees generated from two of the full realizations that occurred during the quarter. In the fourth quarter, we recorded a decrease in net assets resulting from operations of $1.2 million, a decline of $5.1 million compared to Q3, which is primarily driven by our mark-to-market losses recognized in the portfolio this quarter, partially offset by the realized gains and investment income earned in excess of our distributions declared.

Our risk ratings during the quarter showed that 74.8% of our portfolio positions carried either 1 or 2 rating, lower than 83.5% reported in the prior quarter. The decline was driven by for three portfolio companies that were fully realized during the quarter that have been rated on 1 in the prior quarter, in addition to investments in five portfolio companies, which were downgraded to a 3 rating in Q4. 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’s performing according to initial expectations. Regarding the JV specifically, one portfolio company fully realized and one new asset was transferred during the fourth quarter in exchange for cash of $8 million.

As of December 31 2022, the JV’s portfolio help positions in 28 portfolio companies with an aggregate fair value of $284.3 million compared to 28 portfolio companies at a fair value of $280.9 million in Q3. The investment in the JV continues to be accretive to the BDC’s earnings. As we have noted in prior calls, the yield on the 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 $26.3 million at the end of Q4, including $16.8 million restricted cash.

As of December 31 2022, the Company’s asset coverage ratio for borrowed amounts as defined by the 1940 Act was 174.7%, which was above the minimum asset coverage ratio of 150%. Our Q4 net effective debt to equity ratio after adjusting for cash on hand was 1.26 times as compared to 1.22 times in the prior quarter. Before I conclude and open up the call to questions, I’d like to again highlight our distributions. On November 14, 2022, we declared a distribution for the quarter ended December 31, 2022 of $0.355 per share to stockholders of record as of December 21st. The dividend was paid on January 4, 2023, marking the Company’s 41st consecutive quarterly distribution. This speaks to both the consistent strength of the platform as well as a resilient fuel source and capabilities and being able to create a well balanced portfolio, generating consistent current income.

In addition to this quarterly distribution, we did declare a special distribution of $0.05 per share for stockholders of record as of October 31, 2022. The distribution was paid on December 9, 2022, and inclusive this special distribution, total distributions paid in 2022 amounted to $1.47 per share. Finally, this morning, we announced that our Board declared a first quarter distribution of $0.355 per share, to be payable on April 4, 2023 to stockholders of record as of March 24, 2023. This will mark the Company’s 42nd consecutive quarterly distribution paid since our IPO in December 2012, with all distributions consistent at the rate of $0.355 per share per quarter. In addition to the quarterly distribution, our Board declared a special distribution of $0.07 per share.

Timing of this special distribution is concurrent with the Q1 regular dividend, and is to be payable on April 4, 2023 to stockholders of record as of March 24, 2023. As we said previously, we will continue to evaluate a quarterly distribution and future special distributions both in the near and medium term based on the core earnings power of portfolio in addition to other relevant factors that may warrant consideration. With that, I’ll turn the call over to the operator for your questions. Operator?

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Q&A Session

Operator: Thank you, sir. The floor is now open for your questions. Our first question will come from Mickey Schleien with Ladenburg Thalmann.

Mickey Schleien: Stuart, Joyson, thanks for your really thorough remarks. It’s quite helpful. So I just have a couple of questions. Could you give us a sense of where the cash interest coverage ratio was of the on balance sheet portfolio based on fourth quarter interest rates?

Stuart Aronson: Joyson, do you have that information or is that something we need to get for later sharing?

Joyson Thomas: Yes. The cash interest coverage ratio underlying portfolio, we don’t actually have that readily available. Let us see if we can try to get this for you during the call.

Mickey Schleien: Okay. Meanwhile, could you tell us what kind of trends you’re seeing in revenues and EBITDA of the on-balance sheet portfolio and where the average EBITDA level stands today?

Stuart Aronson: Mickey, we just completed a full portfolio review for all the deals in our organization, both performing and troubled. And the ratio that we saw compared to closing leverage was about 40% of our deals are experiencing higher EBITDA and have lower leverage than closing. About 40% of our deals have lower EBITDA and higher leverage than closing, and about 20% of our deals are about static with closing leverage and even EBITDA levels. So very balanced performance, with the caveat being that the consumer facing accounts have seen anywhere from moderate to severe demand decreases, and leverage on those consumer facing accounts is up significantly.

Mickey Schleien: My last question, if I’m not mistaken. You have some unsecured notes due this year. Just curious whether the terminology in the credit facility will allow you to repay those from the credit facility or will you have to divest some assets to pay those off?

Stuart Aronson: We have the availability under our existing credit facility to borrow, to replace the unsecured notes in their entirety. Whether we will do that under our secured facility or whether we will issue new unsecured notes has not yet been determined. But again, we do have the ability under our facility to fund the full amount that is maturing, without having to sell any assets.

Operator: Our next question comes from Bryce Rowe with B. Riley.

Bryce Rowe: I wanted to maybe start on the comments you just made to Mickey’s question there, Stuart. The portfolio review you just finished, the financials that you get from the portfolio companies, were they as of the end of September or end of December?

Stuart Aronson: The vast majority of our companies, because they’re mid market and lower mid market, we get reporting that is quicker than what you see in the upper mid market and large cap deals. And so, we timed our portfolio review this week, because the vast majority of the companies had already reported their December numbers to us. So, not for all the companies. But I would say for over 90% of our companies, we had year-end results.

Bryce Rowe: Okay. That’s helpful. And certainly reassuring to know that. Around the dividend, Stuart, you obviously in your prepared remarks talked about the potential for an increase, and some discussion around a dividend increase at the board level, what would kind of put you in a position to actually increase as opposed to maybe taking a construct of a base plus a supplemental that we’ve seen many BDCs employ here?