Harvest Capital Credit Corporation
Q3 2018 Earnings Call Transcript

Published: 8 Nov 2018

[Operator:]

Good morning. My name is Bella, and I will be your conference operator today. At this time, I would like to welcome everyone to the Harvest Capital Credit Corporation Q3 2018 Earnings Call. [Operator Instructions]. Thank you. Bill Alvarez, Chief Financial Officer, you may begin your conference.

[Bill Alvarez:]

Okay. Thank you, operator. Good morning, everyone, and thank you for participating in this conference call to discuss our financial results for the third quarter ended September 30, 2018. I am joined today by our Chairman and Chief Executive Officer, Joseph Jolson; and by Richard Buckanavage, our Managing Director and Head of Business Development. Before we start, I will provide a disclaimer regarding any forward-looking statements that we make during this presentation. This presentation contains forward-looking statements, which relate to future events or Harvest Capital Credit's future performance or financial condition. These statements are not guarantees of future performance, condition or results, and involve a number of risks and uncertainties. Actual results may differ materially from those in the forward-looking statements as a result of a number of factors, including those described from time to time in our filings with the Securities and Exchange Commission. Harvest Capital Credit undertakes no duty to update any forward-looking statements made herein. Now I'll turn the call over to Joe.

[Joseph Jolson:]

Thank you, Bill. We had a good quarter with $0.25 per share of net investment income that, while flat with our second quarter, included normal levels of incentive fees. Although we had a modest portfolio decline in the period, we do have a pipeline of opportunities that we anticipate could close by year-end. Given the near-term outlook for continued high payoffs, we now think it could take a few more quarters to redeploy our existing capital to our historical leverage target of 0.81. As such, our Board of Directors authorized a 250,000 share repurchase program through June of 2019. Asset quality was relatively stable in the quarter, with an increase in the risk rating due to payoffs of higher-rated investments and not the incremental problem assets. We continue to believe that renewed growth as well as the resolution of our 2 credits, rated 4 and 5, will help to temper this metric in the future. I'll turn the call back over to Bill, then Rich will discuss some outlook of our investment business, and then I'll sum up. Bill?

[Bill Alvarez:]

Okay. Thanks, Joe. Net investment income for the quarter was $1.6 million or $0.25 per share compared to $1.6 million or $0.24 per share in the third quarter of 2017. The year-to-date 2018 net investment income was $4.4 million or $0.69 per share versus $6.3 million or $0.99 per share for the 9 months of 2017. Net income for the quarter was $0.6 million or $0.10 per share compared to a loss of $0.3 million or $0.05 per share in the third quarter of 2017. For the 9 months ended September 30, 2018, net income was $3.5 million or $0.55 per share compared to net income of $0.1 million or $0.02 per share for the 9 months ended September 30, 2017. Moving on to some details regarding the quarter. Net investment was -- net investment income was flat for the third quarter of 2018 compared to 2017 as well as our quarter-end balance in our investment portfolio. However, I would like to highlight a few aspects of our operations. Total investment income decreased $0.5 million in the third quarter of 2018, principally as a result of lower fee income earned in 2018 as compared to 2017. In the 2017 quarter, the company exited $38.7 million of investments, which resulted in such higher fee income recorded last year. Our operating expenses decreased $0.5 million in the 3 months ended September 30, 2018 as a result of the following. During the quarter, during the third quarter of 2017, the company incurred a $0.6 million loss on the redemption of its 2020 notes, for which there is no comparable 2018 amount. As a result of the 2020 notes being redeemed in 2017, we realized $0.2 million of lower interest expense in the third quarter of 2018. In 2017, we were required to provide a 30-day notice of redemption and, accordingly, incurred additional interest expense as a result of having both the 2020 notes as well as the 2022 notes outstanding in the same 30-day period. In the third quarter of 2018, our administrative service fees were $0.1 million lower compared to 2017. And we recorded $0.4 million of incentive fees in the third quarter of 2018 when no incentive fees were incurred in the comparable 2017 quarter. Net income increased by $1 million in the quarter ended September 30, 2018, compared to the quarter ended of September 30, 2017. During the third quarter, the company recorded net realized and unrealized losses on investments of $1.5 million or a net of $1 million after taking into consideration a $0.5 million deferred tax benefit, resulting from a reduction in unrealized gains in our tax blocker subsidiary as compared to the quarter ended September 30, 2017, where the company recorded net realized and unrealized losses on investments of $1.9 million. We recognized income from fee amortization of $0.3 million in the 3 months ended September 30, 2018, as compared to $1 million in the comparable 2017 quarter. The higher fee amortization income in 2017, as I previously mentioned, resulted from the company exiting $38.7 million of investments in 2017. Our fees are deferred until the year earned, amortizing the income over the likely investment using the effective yield method or fully recognized when investment payoff occurs. As a result, our fees will fluctuate quarter-to-quarter, depending on portfolio activity. As of September 30, 2018, the fair value of our portfolio was $111.9 million, with a cost base of $115.7 million, reflecting $3.8 million of net unrealized depreciation in the portfolio at the end of the quarter. As of September 30, 2018, we had a debt balance of $54.6 million, consisting of $25.8 million of bank debt and $28.8 million in unsecured notes for a debt-to-equity ratio of approximately 69%, up from approximately 56% at December 31, 2017. At quarter-end, we had $20.6 million of cash and approximately $4.6 million of undrawn capacity on our $55 million credit facility, which we renewed effective on October 30, 2018, for an additional 18-month extension of the revolving period to April 30, 2020, and maturity date to October 30, 2021. Our cash and borrowing capacity provides us with sufficient liquidity in order for us to execute our business plans for 2018 and into 2019. In addition, we have 2 syndicated loans totaling $6.6 million, which we can monetize into cash to be invested in our core lower middle-market strategy as attractive opportunities arise. As of quarter-end, our net asset value was $12.33 per share, down $0.33 per share from December 31, 2017, principally as a result of paying $0.87 in distributions for the 9 months ended September 30, 2018, versus $0.55 of an increase in assets from operations in the same period. For the quarter ended September 30, 2018, our net investment income was $0.25 per share, slightly below our distribution of $0.285 per share. Of the aggregate distributions declared and to be paid through December 31, 2018, of $1.14 per share, the company estimates that on a tax basis and subject to revision, those distributions will be derived as follows

[Richard Buckanavage:]

Thank you, Bill. Our third quarter's deployment was $6.5 million, but again, this quarter, repayments of $15.6 million exceeded deployments. The deployment activity was comprised of 3 transactions into existing portfolio companies and 1 brand new financing. We had hoped to have 1 to 2 more transactions closed during the third quarter, having won 4 new mandates in the prior quarter. For a variety of reasons, the new mandates incurred delays in closings, so most will close in the current quarter. We decided to seize pursuing one of those 4 mandated transactions, so currently, we have 3 mandates that are scheduled to close by year-end. Because we are seeking to partner with JMP-managed funds on 2 of the 3 mandates, the financing amounts' totals may still fluctuate, but are likely to result in commitments of between $14.5 million and $15.5 million for HCAP. Of the 3 mandates we are currently working on, all 3 involve floating rate unitranche debt structures. The current state of the market in which we compete continues to be competitive and pricing remains the primary source of competition. While spreads have been stable now for the better part of 2 quarters, we will need to see spread expansion in order to pursue all unitranche financing opportunities that we uncover through our marketing efforts. During the third quarter, we, again, had to pass on a number of credit-worthy unitranche financings due to spreads that would result in ROEs that would not be accretive to HCAP's dividend level. Despite the competitive landscape, our pipeline remains solid. While the absolute number of opportunities is lower than Q2 quarter-end, the average deal size is larger and, therefore, the dollar value of the pipeline is not that dissimilar. We are particularly pleased with the quality of the pipeline, which contains transactions involving borrowers with a defensible competitive characteristics we find attractive, combined with reasonable leverage requests. Consistent with the composition of our current mandates, the pipeline is heavily weighted towards unitranche debt structures. In order to pursue a larger number of transactions in this quarter and going forward, we're increasingly seeking to partner with other firms, including funds managed by JMP, which will allow HCAP to compete for financings that are beyond our preferred final hold size. We are aware of a few potential repayments in the portfolio, as Joe mentioned. However, with the 3 However, with the 3 mandates in hand that are expected to close during Q4, we are optimistic about our ability to generate net positive portfolio growth this quarter. As we move into 2019, we remain bullish about HCAP's prospects for further portfolio of growth as we avail ourselves the higher balance sheet leverage, enabled by the Small Business Credit Availability Act, which subjects us to reduce statutory asset coverage ratio. Even if credit spreads do not expand in 2019, that additional leverage should expand the universe of potential financing opportunities that we can't pursue, which should result in higher number of term sheets issued and, therefore, mandates awarded. With that, I'll turn it back over to Joe.

[Joseph Jolson:]

Thanks, Rich. Summing up, our mission is very clear. First and foremost, deploy $60 million in net new investments through year-end 2019 at risk-adjusted yields that would support and hopefully grow our current dividend levels. Second, actively manage our 2 rated credits, 4 and 5 rated credits, and minimize any migration of the 3-rated credits going forward. If we execute well on these initiatives, we are optimistic that our stock price could, once again, trade consistently above net asset value. As such, our Board of Directors authorized the repurchase of the 250,000 shares in open market transactions through June of 2019. We want to thank our dedicated employees and directors for their hard work in helping us accomplish these goals. Thanks, everyone, for your interest in Harvest Capital Credit, and with that, operator, we'd be happy to answer any questions. Thank you.

[Operator:]

[Operator Instructions] Your first question comes from the line of Brian Hogan with William Blair. Your line is open.

[Brian Hogan:]

Good morning. I've got a question on your, on the pipeline, and then potentially new investments there and yields. The yields on the new investments, I appreciate your commentary about -- the stuff is stabilized. But compared to the stuff that's running off, how much, I guess, compression are we seeing in the yields?

[Joseph Jolson:]

Yes, why don't I have Rich take a crack at that.

[Richard Buckanavage:]

Yes, Brian. I think you need to break it up into, by asset class. So absolutely, we can't compare a repayment of a sub-debt investment to a unitranche, but apples-to-apples comparison, we are seeing pretty much a wash on the unitranche side. For the most part, we haven't really changed our unitranche pricing all that much. Again, going back to my comment about supporting the dividend, we maintained some discipline on our pricing on the unitranche side, so I don't know that you'll see a big difference between what's being repaid and what we're deploying. I think there's probably some compression though on the junior debt side, on the subordinated debt side. It's probably in the neighborhood of about 100 basis points, maybe even slightly higher than that because some of these repayments are a couple years old, and obviously, subject yields have compressed during that time frame. I hope that answers your question.

[Brian Hogan:]

Sure. And these starts, should start to level off over the course of next year? I mean, how much, do you see anything degrading further? Or...

[Richard Buckanavage:]

No. No, we don't. As I've said in my prepared remarks, we don't know that spreads have changed all that much. I think they've settled in here for the last couple of quarters, but they've settled at levels that aren't -- not as attractive as we'd like them to be. But I think on the subject side, while we've seen more compression there than on unitranche side, it has stabilized as well. So in other words, I don't see sub-debt yields going lower further. I think they've stabilized as well as the unitranche yields.

[Brian Hogan:]

Sure. And then I guess, as you go, move to larger investments and you partner with other firms like JMP, has there lower rates on the larger investments that you maybe would typically see? Or is that not the case, I guess? And then with that, have you -- are you beginning to change any of your underwriting criteria for those larger size?

[Richard Buckanavage:]

Yes. Just to put in my comments into some context, what we're talking about in terms of larger transactions, so instead of solely looking at or primarily looking at transactions that involve hold sizes of between -- up to maybe $7 million, now we're looking at about hold sizes of maybe 10 -- or transaction sizes of $10 million to $12 million. But again, with the same hold size eventually, so bringing in a partner for the overage. So we're not talking about dramatically changing our origination strategy. It's really an uptick from maybe an average EBITDA company of between $2 million and $4 million to $2 million and $6 million. So it doesn't dramatically change the yield that we're seeing in our pipeline.

[Brian Hogan:]

All right. And I appreciate your discipline in the ROE -- in your underwriting stuff to be dividend-accretive in ROE. But I guess, you haven't met the dividend for several quarters at least now. And I guess, in what scenarios do you need to cut the dividend? Or is just the ramping-up that growth going to get you back to covering the dividend? Just kind of chat on the outlook of the dividend, please?

[Joseph Jolson:]

Well, let me -- I'll take that one, and maybe Bill might add something, too, if I don't cover it completely. But yes, we wouldn't be maintaining the dividend at the current level if we didn't think that our growth strategy, without raising any new outside capital will get us to a level that we earn the dividend and hopefully, exceeded over a reasonable period of time, say by the fourth quarter of next year. So this quarter, even though it was flat with last quarter, included a full incentive fee payment. So that catch up part of the incentive fee contract. So additional growth beyond this should start to layer into getting above that $0.25 level and sequentially improving as we go through next year, with that caveat, which is why we announced the share buyback near term, is that we are going to have some higher repayments and we welcome them because we're in some mature credits that we'd like to redeploy the capital. And so we'll have to burn through those repayments before you see that. Now, Brian, as you know, putting on loans doesn't really help the quarter that you put them on it. It helps the next quarter. There's a 1 quarter kind of average balance lag to that type of thing. So I think you should start to see -- if we execute on the plan that I outlined in my prepared remarks, I think you should start to see migration above that quarterly level of the $0.25 by the, maybe the second quarter of next year, and then obviously, that should continue in the third and fourth quarter. So hopefully, that answers your question.

[Brian Hogan:]

It does. And the leverage ratio that you're targeting eventually, obviously, you have, you said 0.8 by year-end or...

[Joseph Jolson:]

Well, that's the old target, right? So the 0.8 was our target before they changed the BDC rules. And assuming we get the approval in the first quarter from our senior lender, we think that we'll have room to expand on that, just with the current advance rates that we get on our assets to somewhere between 1.25 to 1.4 times.

[Brian Hogan:]

Okay. And you're hoping to get there, assuming you have the approval, by end of '19? Or what is the expectation?

[Joseph Jolson:]

No, I think I said in my prepared remarks, I'm pretty sure I said, let me go look back. It was at the end, I think I said, I did, $60 million of net new investments, right? So that wouldn't get us, that gets us above the 1.0

[Brian Hogan:]

All right.

[Joseph Jolson:]

So there still would be some room beyond that.

[Brian Hogan:]

Sure. That's it for me for now. Now thank you.

[Joseph Jolson:]

And Brian, by the way, buying back our stock at current levels is highly accretive to the earnings as well. And while it's not a, it's not our preferred long-term business plan to reinvest the capital that way, because we think it's more accretive through growth, it is accretive and, of course, we always have the option to do more buybacks if it takes longer.

[Brian Hogan:]

Right. No, I definitely think buying back stock here at 90% of book value makes a ton of sense, especially considering the competitive environment out there. So...

[Joseph Jolson:]

Okay, great. Thank you for your questions.

[Operator:]

Your next question comes from the line of Ryan Lynch with KBW. Your line is open.

[Ryan Lynch:]

Good afternoon. Just wanted to make sure I get a clarification. As far as the 2

[Joseph Jolson:]

Bill, you want to take that one?

[Bill Alvarez:]

Yes. The only thing is that we have to get to May, when we have a year that expires and the board approves it and we just have to go to our senior lender to get that approval, which we've kind of baked into our amendment that we just had right now, renewal of our credit facility in October. We have that baked into them as far as having that happen in our first quarter. So we have that teed up and hopefully we'll get through it.

[Ryan Lynch:]

Okay. That's helpful. And then so one thing I just wanted to get a clarification on. I believe the intention was, with the act, there's a 2

[Joseph Jolson:]

We are hoping not to put the capital work at lower-yielding deals, but once we're officially allowed to put on more leverage than 1

[Richard Buckanavage:]

Yes, Ryan, I think there's a concept that's getting lost here. Once we avail ourselves to the additional leverage, there are unitranche financings that will be attractive to us and accretive to the dividend that will be lower yielding than the unitranche investments that we've historically pursued. However, there still is a functional level beyond which we can't go because they're not accretive to the -- either support or accretive to the dividend. So I think that was my comment, which is that, going forward, as we get closer to that May date, a transaction that -- but for example, priced at L-850 [ph], may not work for us today, but it very well may and probably does work for us. And by doing that, that opens up a whole another subset of the universe of potential deals we can pursue. So but that doesn't mean that we can't go to L-5, I guess, is my point. So there still remains a functional limitation beyond which we can go, a floor, if you will. But as we do get closer to May, we can very much make that decision. And keep in mind, my comments about passing on deals were rear view mirror comments. In other words, those decisions were being made in June, July, August when we were 9, 10 months away from availing ourselves to leverage, the additional leverage. And as we get closer to that May time frame, we could very much make the decision to pursue transactions that are accretive post that May time frame, but not -- obviously, the longer you're away from that period of time, the more challenging it is to make those decisions to book assets that makes sense mid '19 versus what makes sense today. We've opted not to pursue transactions that are -- that only are subject to the added leverage.

[Joseph Jolson:]

Yes. The other thing I'd add to that, Ryan, what Rich has said, is that the loss at 1 year after the board approves it. But functionally, if our maximum target will be 0.8, right, and our senior lender approves it in the first quarter, then in theory, we could go from 0.8 to 1.0 between then and early May, right?

[Ryan Lynch:]

Yes. Yes, I can...

[Joseph Jolson:]

So functionally, we're not, we probably aren't going to need to wait until early May, is what I'm saying.

[Ryan Lynch:]

Yes. And Rich, I get your point as yes, there are some absolute yields that just don't make sense and the lower ones that you can't put on. And yes, I guess my thought was just that you know when the 2

[Richard Buckanavage:]

Yes. And Ryan...

[Joseph Jolson:]

Yes, we agree with you.

[Richard Buckanavage:]

Yes. And I think I'd highlight, Ryan, that the amendment that we closed with our lender's about a week old. So again, going back, the decisions to act on certain deals were made a couple of months ago prior to finalizing the negotiations for the extension and hopefully, the access to the additional leverage. So I don't disagree with you, but again, it's just really a timing issue. Now we obviously have better clarity on availing ourselves to that additional leverage.

[Ryan Lynch:]

Okay. Those are my only questions that I had. I appreciate that time today.

[Operator:]

[Operator Instructions] There are no further questions at this time. Presenters, please continue.

[Joseph Jolson:]

Yes. Thank you, guys, for your interest. And we look forward to reporting our fourth quarter results in the, Bill, I guess sometime in March, right? Early March of next year?

[Bill Alvarez:]

Yes, that's right, Joe. We haven't set a date yet, but we'll certainly will do that.

[Joseph Jolson:]

Okay, great. Thank you, everyone, and we'll see you, speak to you soon. Take care.

[Operator:]

This concludes today's conference call. Thank you for your participation. You may now disconnect.