Q2 2023 WhiteHorse Finance Inc Earnings Call
Participants
Joyson C. Thomas; CFO & Principal Accounting Officer; WhiteHorse Finance, Inc.
Stuart D. Aronson; CEO & Director; WhiteHorse Finance, Inc.
Erik Edward Zwick; Director; Hovde Group, LLC, Research Division
Mitchel Stuart Penn; Research Analyst; Oppenheimer & Co. Inc., Research Division
Sean-Paul Aaron Adams; Research Associate; Raymond James & Associates, Inc., Research Division
Unidentified Analyst
Jacob Moeller
Presentation
Operator
Good morning. My name is Mike, and I'll be your conference operator today.
At this time, I would like to welcome everyone to the WhiteHorse Finance Second 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 12 p.m. Eastern Time. The replay dial-in number is (402) 220-7273 and 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, sir.
Jacob Moeller
Thank you, operator, and thank you, everyone, for joining us today to discuss WhiteHorse Finance's Second Quarter 2023 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 2023 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 D. Aronson
Thank you, Jacob. Good morning, and thank you for joining us today.
As you're aware, we issued our press release this morning, and I hope you've had a chance to review our results for the period ending June 30, 2023, 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, I will open the floor for questions.
This morning, I'm pleased to report strong performance for the second quarter of 2023. Q2 GAAP net investment income and core NII was $10.6 million, $0.456 per share, which more than covered our quarterly base dividend of $0.37 per share. Although our core NII declined by $0.005 per share compared to Q1, Q2 core NII increased by 34.5% -- increase over year-over-year. NAV per share at the end of Q2 was $14, representing a 1.4% decrease from the prior quarter. NAV per share was impacted by a $6 million net mark-to-market loss in our portfolio. These markdowns are related to company-specific performance in 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. We saw a relatively quiet quarter with regards to originations and repayments. All transaction activity for the quarter remained slower than recent history. We have seen a pickup relative to Q1 across our markets. We have market prices trending in the direction conducive for increased deal activity, as I will discuss shortly. In Q2, gross capital deployments totaled $23.8 million, $19.3 million funding, 3 new originations and the remaining $4.5 million funding add-ons to existing portfolio investments. Of our new originations in Q2, 2 were sponsored deals and 1 was non-sponsored with an average leverage of approximately 3.7x debt to EBITDA. I note that these deals were all first lien loans, which spread to 675 basis points or higher, resulting in an average all-in annualized interest rate of 12.6% across the 3 originations. At the end of Q2, 97.2% of our debt portfolio is first lien and 100% was senior secured.
In Q2, total repayments and sales were $28.8 million, primarily driven by 3 complete realizations and there is also $1.5 million in net repayments from our revolver commitments. As previously discussed on our last earnings call, one of the full realizations was a successful sale of our formerly troubled asset Arcole Holding. In April of this year, we exited our investment in Arcole with approximately 1.25x 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. Looking forward, we have seen some increased M&A activity relative to earlier in the year, and as a result, anticipate prepayment activity to pick up in the back half of the year. We believe that investment repayments when they occur likely allow WhiteHorse to redeploy that capital into assets with the same or higher yield.
During the quarter, the BDC transferred 2 new deals and 1 add-on to the Ohio STRS JV, totaling $12.6 million in exchange for cash of $10.8 million and $1.8 million in kind contribution to the STRS JV. I will discuss activity within the JV shortly. Although repayments and sales outpaced originations at the end of Q2, the company's net effective leverage was 1.25x, up slightly from 1.23x at the end of Q1. 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 1.35x leverage.
With that in mind, I'll now step back to bring our entire investment portfolio to focus. After the effects of the STRS JV transfers as well as $6 million in net mark-to-market changes, $0.3 million in realized losses and $1 million of accretion, the fair value of our investment portfolio was $728.4 million at the end of Q2. This compares to our portfolio of fair value of $749.2 million at the end of the previous quarter. The weighted average effective yield on our income-producing debt investments increased to 13.4% as of the end of Q2 from 13.2% at the end of Q1, the variance was primarily driven by an increase in the portfolio's base rate.
We continue to utilize the STRS Ohio joint venture successfully. The JV generated investment income to the BDC of approximately $3.7 million in Q2, relatively unchanged from the $3.8 million in Q1. As of June 30, the fair value of the JV's portfolio was $324.5 million. And at the end of Q2, the JV's portfolio had an average unlevered yield of 12.2%. Comparatively, the average yield was 11.8% in Q1 and 8.7% in Q2 of 2022. The increase in unlevered yield is primarily due to rising base rates. With the rising base rates, the JV currently producing an average annual return on equity in the mid-teens of the BDC. We believe WhiteHorse's equity investment in the JV provides attractive return to shareholders. The JV has approximately $35 million of capacity, which supplements the BDC's existing capacity.
Transitioning to the BDC's portfolio more broadly. There are some markdowns in the portfolio in Q2, as I mentioned earlier. I will elaborate on specific market dynamics shortly, but note that we continue to see credit pressure as most acute in consumer-facing names. BDC's Q2 mark-to-market declines were primarily driven by our investments in Crown Brands, Arcserve, StorageCraft, Sklar Holdings and American Crafts, which were partially offset by mark-to-market activity increases across the portfolio. As I mentioned on our last call, our investment in American Crafts and Sklar Holdings and the restructurings during Q1 as both companies have consumer exposure and have been experiencing demand softness. WhiteHorse elected to invest liquidity in both companies and return for control equity positions in each company. Alongside restructuring professionals at H.I.G., 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.
As of the end of Q2, our investments in Arcserve, term loan and Crown Brands second lien were placed on nonaccrual, Playmonster's first lien term loan also remains on nonaccrual. Arcserve was moved to nonaccrual in May, resulting in an impact of approximately $0.02 per share of net II for the quarter along with other lenders who are actively working to restructure the company with an aim to return a portion of the debt accrual status in Q3 or Q4. Crown Brands, a second lien loan was moved to nonaccrual on June 30 and, therefore, did not contribute to Q2 results. Expect the Crown Brands will remain on nonaccrual until the company achieves its projected performance levels. I would note that the company sponsor has been supportive of the company, providing equity injections over the past 12 months. At this time, Crown Brands continues to make interest payments. The investments on nonaccrual totaled 2.7% of our total debt portfolio at fair value at the end of the quarter.
As we've shared before, we are seeing some pressure in our portfolio in the general economy, primarily in the consumer segment. We remain vigilant in monitoring our portfolio of companies as we have not seen demand weakness in other sectors, including general industrial, B2B, health care, TMT or financial services. Additionally, our portfolio includes mostly noncyclical or light cyclical borrowers. We hold no direct exposure to oil and gas, auto or restaurants and very little exposure in the construction sector. The vast majority of our deals have strong covenant protection. We are finding that private equity firms we partner with are generally supporting their credits with new cash or contingent equity as needed. In general, we observed an increase in borrower revenues, which can be attributed to inflation. About half our portfolio companies have been able to maintain margins by successfully passing through increased costs through higher prices. In the other half of the portfolio, we've seen an uptick in leverage, which thus far has only had a modest impact on our typical borrowers' debt service coverage.
Turning to the broader lending market. The back half of 2022 saw a material correction in direct lending markets as the combination of general economic weakness, significant inflation and rising interest rates applied better pressure on borrowers. While these conditions persisted through Q1 of this year, we saw Q2 begin shift back in the direction of normal market activity. Late in Q1 and early Q2, the quality of deals we were seeing was generally lower than those we have been seeing in late 2022 with many borrowers experiencing material credit issues. As we move through Q2, there was an increase in activity from the banking community and more competition came back into the markets as conditions moved towards normalization in terms of pricing and covenants. The quality of deals we looked at also improved in Q2.
As of the end of Q2, the markets have once again started treating lower mid-market companies, more conservatively than mid-market companies with lower mid-market deals being priced 25 to 50 basis points higher than comp mid-market deals. This is a reversal from the abnormal lending conditions we saw in 2022. This represents a return to a more normal market condition where lower mid-market companies get less leverage and more priced than mid-market borrowers. It's been over a year now where the market has been inverted and lower mid-market companies were getting equal or better pricing than mid-market due to capital limitations in the market. In the mid and lower end of the mid-market, which is our focus, leverage is generally up 0.25 to 0.5 turn compared to 2022. Lower mid-market deals are being levered 4 to 5x.
Pricing, which was 625 to 700 has moderated to 600 to 675. Also, loan-to-value is running between 40% and 50% on sponsor deals and 30% to 50% of non-sponsor deals. As an example, non-sponsor origination in Q2 was done at a loan-to-value of 45% with pricing of 750 for what we believe is a like cyclical company. The non-sponsor market continues to hold steady compared to the sponsor market, and we have seen a number of attractive non-sponsor deals, which are being developed across our pipeline. The deals that we're continuing to work on are mostly noncyclical or light cyclicals. And given the BDC's limited capacity, we continue to be highly selective about which credits will enter the BDC. WhiteHorse has consistently and deliberately chosen to deploy capital into deals with more conservative terms with premium pricing. And as such, has built a portfolio, we believe, is well equipped to withstand a potential economic downturn.
Our recessionary indicators have still been minor. We maintain expectations for a weaker economy in 2024 and work to ensure that the companies we invest in can weather that storm. We are also increasingly focused on cash flow coverage and the risk that rates will continue to rise, although the forward curve indicates rates will decline.
With that said, our pipeline returned to an all-time high. Our 3-tier sourcing architecture continues to provide the BDC with differentiated capabilities, and we continue to derive significant advantages from the shared resources and affiliation with H.I.G. where as a leader in the mid-market, lower 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. Currently, the BDC has very limited balance sheet capacity, but we anticipate that capacity to grow over the next 2 quarters given expected repayments. We anticipate utilizing that capacity provided by repayments, when they occur, continue to rotate into strong, high-yielding assets, leading to strong income and ongoing coverage of our dividend.
With the conclusion of the quarter, we remained cautiously optimistic for the second half of the year despite sustained concerns of economic softening, we believe continued execution on our 3-tier sourcing approach and rigorous underwriting standards to leave WhiteHorse well positioned to navigate any potential future economic challenges and continue delivering for our shareholders.
With that, I'll turn the call over to Joyson for additional performance details, a review of our portfolio composition. Joyson?
Joyson C. Thomas
Thanks, Stuart, and thank you, everyone, for joining today's call.
During the quarter, we recorded GAAP net investment income and core NII of $10.6 million or $0.456 per share. This compares with Q1 GAAP NII and core NII of $10.7 million or $0.461 per share and our previously declared quarterly distribution of $0.37 per share. Q2 fee income decreased marginally quarter-over-quarter to $0.9 million in Q2 from $1 million in Q1 with Q2 amounts being highlighted by amendment fees of approximately $0.6 million generated from our investments in Future Payment Technologies, CleanChoice Energy, BBQ Buyer and Team Car Care Holdings. For the quarter, we reported a net increase in net assets resulting from operations of $3.9 million. Our risk ratings during the quarter showed that 76.3% of our portfolio positions carried either a 1 or 2 rating, slightly higher than the 73.2% reported 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 the 2 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, we transferred 2 new deals and 1 add-on transaction totaling $12.6 million in exchange for cash proceeds of $10.8 million and a $1.8 million in-kind contribution. As of June 30, 2023, the JV's portfolio helped positions in 32 portfolio companies with an aggregate fair value of $324.5 million compared to 30 portfolio companies at a fair value of $308.9 million as of March 31, 2023. Subsequent to the end of the second quarter, the company transferred 1 new portfolio company investment to the JV. The investment in the JV continues to be accretive to the BDC's earnings generating a mid-teens return. 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 $23.1 million at the end of Q2, including $12.7 million of restricted cash and approximately $96 million of undrawn capacity available under our revolving credit facility. As of June 30, 2023, the company's asset coverage ratio for borrowed amounts, as defined by the 1940 Act, was 175.9%, 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 approximately 1.25x as compared to 1.23x in the prior quarter.
Subsequent to quarter end and as discussed on prior earnings calls, $30 million of unsecured notes paying 6% interest matured and were repaid with existing cash on hand and proceeds drawn from our revolving credit facility. As mentioned on those past calls, the capacity under revolving credit facility allowed us to comfortably repay these notes and pro forma for this borrowing, our remaining capacity under our JPM line still provides sufficient liquidity to meet our obligations, including relative to our existing unfunded commitments to portfolio company borrowers. With that said, we continue to monitor the debt capital markets and recent offerings in both the retail and institutional space and may explore the possibility of issuing new unsecured notes depending on market conditions.
Before I conclude and open up the call to questions, I'd like to highlight our distributions again. On our previous earnings call, it was announced that our Board had declared an increase in the company's quarterly base distribution as well as implemented our formulaic quarterly supplemental distribution program. The amendments to WhiteHorse Finance's distribution framework took effect at the beginning of Q2. The Board did not declare a supplemental distribution for this quarter, which is consistent with our formulaic supplemental distribution framework.
Specifically, for Q2 2023, we had generated $0.456 per share of NII, which was in excess of our previously declared regular base distribution of $0.37 per share. The framework would then have us take 50% of the $0.086 per share excess and routed to the nearest cent, which would equate to a proposed $0.04 per share supplemental distribution. However, given our negative NAV per share movements during Q1 and Q2 2023, primarily as a result of unrealized mark-to-market declines in the portfolio, the $0.15 per share NAV decline limitation was a factor for this quarter's calculation. We believe this 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.
On May 9, 2023, we declared distribution for the quarter ended June 30, 2023, of $0.37 per share to stockholders of record as of June 21. That dividend was paid on July 5, 2023, marking the company's 43rd consecutive quarterly distribution, all at a level of $0.355 per share or higher. 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 third quarter distribution of $0.37 per share to be payable on October 3, 2023, to stockholders of record as of September 19, 2023. This will mark the company's 44th consecutive quarterly distribution paid since our IPO in December 2012. 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 the portfolio in addition to other relevant factors that may warrant consideration.
With that, I'll now turn the call back over to the operator for your questions. Operator?
Question and Answer Session
Operator
(Operator Instructions) And our first question comes from Sean-Paul Adams with Raymond James.
Sean-Paul Aaron Adams
Can you quantify the exact number of companies in the portfolio with interest coverage below 1x? And then just provide some general commentary on the rise in amendment activity and the outlook for the rest of 2023?
Stuart D. Aronson
I'll give Joyson a moment to see if he can come up with that number of companies that have a fixed charge below 1.0, but it is a small minority of the overall portfolio. If we can't provide that to you today, we'll get that to you after the call.
In terms of amendment activity, it is, I'd say, at a normal pace, we have real covenants on the vast majority of our deals. And as there is volatility in the economy, we do see some number of companies that are violating those covenants. As I mentioned in the prepared remarks, where we do have covenant problems, we have found the owners of company, both sponsors and non-sponsors, have been generally willing to provide equity support if they had the capacity to do so, where Sklar Holdings and American Crafts are examples where the owners did not have that ability. Our general posture on covenant waivers is we look to get equity support from the owners if the leverage on the company is significantly higher than it was at close. And then we also seek to get a pricing adjustment on the loans to reflect any heightened risk return that we have.
Joyson, just curious, were you able to come up with a number for the number of deals that are at less than 1.0x charge that we need to come back on that question?
Joyson C. Thomas
We'll need to come back on quantifying the specifics that are under 1x. Generally speaking, as a portfolio as a whole though, obviously, the average is much greater than 1x. So as to what you said before, Stuart, it speaks to the overall general coverage of the portfolio as a whole.
Sean-Paul Aaron Adams
Okay. And as a follow-up, can you just comment on the -- I believe you guys said that you predicted a rise in prepayment income over the next 2 quarters. Can you provide some commentary on that, along with just the general margin compression experienced within your portfolio?
Stuart D. Aronson
Not necessarily an increase in prepayment income, but an increase in prepayments of companies. The income will only go up if those companies are still within a period of time where prepayment penalty will be due. The improved general market conditions mean that we have gotten notice that more of the companies in our portfolio are targeted for sale in Q3 or Q4. And so we do expect to see increased prepayment activity compared to what we saw in Q1 and Q2 and the markets were very slow on M&A. There are also a couple of credits we have, where the owners of the company have asked for additional capital, which given our concerns about the economy slowing down in 2024, we are not willing to accommodate. And it is possible that those companies will choose to get financing from another source and repay us because we're not willing to increase the leverage on those credits.
Operator
(Operator Instructions) And our next question comes from Mitchel Penn with Oppenheimer.
Mitchel Stuart Penn
Can you provide some detail on the number or percentage of companies with a loan-to-value greater than 50% in the portfolio?
Stuart D. Aronson
Again, we don't necessarily track portfolio according to LTV. So that is a question that I'm almost sure we're going to need to come back to you on to try to provide an answer. We do have the ability to get that data out of our automated systems. I will tell you that as it regards companies that we financed over the past 2 years, either 0 or close to 0 of those loans have been done at greater than 50% loan to value. And to the extent that we're at more than 50% loan to value, most of the credits would be in that position due to a shift either in the EV of the company or in the earnings of the company over the past couple of years. But we'll work with our Chief Credit Officer to get that data and get it to you.
Operator
And our next question comes from [Ernest Watts with Watts Associates].
Unidentified Analyst
I do appreciate you going over the weak spots. It is a better feel for how the company is doing. I do think there should be more progress. We believe that the [EVA] would be -- the EVA people would be more enthused, but a company has reached $40 million in earnings. And since it's well below that, we live in all at the $7 million in bonuses and urge that independent directors be required to have at least 1 year's take and invest it in shares of the company with their own money, it would suggest that they might be more vigorous in finding spots for progress.
Stuart D. Aronson
Thank you for the commentary, and we will definitely take it under consideration.
Operator
And our next question comes from Erik Zwick with Hovde Group.
Erik Edward Zwick
Just kind of thinking about some of your commentary with regard to the current market environment, offering your exceptionally attractive turns and the pipeline being at an all-time high. But just kind of given where your leverage is today, you've mentioned that your ability to kind of make new investments is somewhat dependent on kind of some of the current portfolio companies prepaying and exiting the portfolio. So just curious from that perspective within an attractive investing opportunity, what are your thoughts today on potentially raising new capital? And if you tested that at all, what the market receptivity is like from that perspective as well?
Stuart D. Aronson
In general, the market is not receptive at the moment to new raises from BDCs. But we do acknowledge that the market opportunity and new investments is attractive. And again, that's one of the things that the Board has taken under consideration and discussed. But at this moment, there are no plans to be raising new capital.
Operator
And at this time, I am currently showing no questions in the queue. I will turn the call back over to today's hosts.
Stuart D. Aronson
All right. I appreciate everybody's time, and we will continue to work hard to deliver value for all of our shareholders. And I appreciate everybody's time and questions. And as always, if there are more things that people would like to see us share on future calls, please let us know in advance of the next call, and we'll do our very best to provide transparency into the operations and performance of the company. Thank you much. Have a good day.
Operator
Thank you. This does conclude today's program. Thank you for your participation. You may now disconnect.
