Harvest Capital Credit Corporation
Q2 2017 Earnings Call Transcript

Published: 10 Aug 2017

[Operator:]

Good morning, my name is Holly, and I will be your conference operator today. At this time, I would like to welcome everyone to the Harvest Capital Credit Second Quarter Earnings Conference Call. All lines have placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I'd now like to turn the conference over to Company's CEO, Richard Buckanavage. Please go ahead, sir.

[Richard Buckanavage:]

Thank you, Operator. Good morning, everyone. And thank you for participating in this conference call to discuss our financial results for the quarter ended June 30, 2017. I'm joined today by our Chief Financial Officer, Craig Kitchin. Before we start our call, Craig, could you provide the Safe Harbor disclosure?

[Craig Kitchin:]

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.

[Richard Buckanavage:]

Thanks, Craig. For the quarter ended June 30, 2017, we generated net investment income and core net investment income of $0.39 per share which fully covers our dividend of $0.34 per share. The dividend coverage was assisted by lower incentive fees this quarter due to the total return feature becoming operative due to portfolio depreciation. Portfolio depreciation this quarter was largely due to one portfolio company CRS Reprocessing; because this investment has been on nonaccrual for some time now, its overall impact on NII has been negligible. Looking ahead due to larger payments that have already occurred in Q3 and resulting fee acceleration than normally a company's early repayments along with approximately $0.44 per share of spillover income maintained from prior quarters, the Board of Directors has decided to declare a special dividend of $0.10 per share. The acceleration of fees and/or early termination fees puts us in a solid position to out earn the dividend in Q3. And with a full quarter's dividend remaining in spillover income, the Board chose to payout this excess to shareholders rather than continue to pay the excise tax. In terms of capital deployment, Q2 2017 was another active quarter for Harvest Capital. We closed four new and two add-on investments totaling approximately $17 million in commitments. Repayments also remained active in Q2. We exited one full and two partial investments during the quarter totaling approximately $6.6 million. As the number of unitranche investments as a percentage of the total portfolio has increased, so too has the level of scheduled amortization that we received in any given quarter. Unlike subordinated debt or mezzanine investments, unitranche financing structures normally contains some level of scheduled amortization. As a result, in Q2 we received approximately $7.6 million in amortization payments. A breakdown of this past quarter's deployment activity is as follows. $1.6 million of equity investments in one existing portfolio company. $4 million of second lien term debt in one new company and $11.4 million of senior secured debt investments in three new and two existing portfolio companies. The deployment in the quarter was comprised of approximately 1.5 million in fixed rate debt investments and 13.9 million in floating rate investments. Our sale full payoff this past quarter continues to track record of successful exits. The full repayment of our senior secured debt investment in WBL2 generated a 19.3% internal rate of return. Subsequent to quarter end, the waiver repayments continued the five additional investments paying off in full totaling approximately 27.7 million. Fox Rent A Car was exited and generated an internal return of 18.9%. We exited two syndicated second lien loans in Novitex and SourceHOV by virtue of our previously disclosed merger. The Novitex and SourceHOV exits generated internal rates of return of 13.3% and 13% respectively. We also exited two core investments, Brite Media which produced an internal rate of return of 13.3% and Mercury Network which generated a combined debt and equity return of 18.8%. Combined with the exit of WBL2 during the quarter and these five exits post quarter end we now have 33 realizations since inception with a weighted average internal rate of return of approximately 19.2%, inclusive of several lower yield in syndicated investments and 20.2% without. From a risk perspective, the portfolio continues to exhibit the acceptable results with a weighted average risk grading of 2.05 at June 30, 2017, a modest uptick from 2.03 at prior quarter end. As of June 30, we had two debt investments and one revenue linked security on nonaccrual status that represents 6.7% of total debt investments at cost and 0.5% on a fair value basis. While we are disappointed in the net loss experienced in the quarter, it's worth noting that the majority of the decline in NAV was attributable to one portfolio company. With CRS another nonaccrual debt investment Peekay acquisition written down to a fair value of zero these are investment will negatively impact future NAV or NII. It's also worth noting that we continue to receive cash payments for the IAG revenue linked security. It was placed on nonaccrual last quarter as a result of slower than anticipated pace of sales of the underlying inventory. But not due to our view of the eventual value for the security and the realization of an attractive return. We continue remain prudent diversification across the portfolio, due to the growth of the portfolio our top five abagore concentration decreased to 33.2% from 33.9% at prior quarter end. And the top 10 abagore concentration decreased as well from 57% at March 31st to 54.4% at June 30. At quarter end June 30, 2017 our portfolio was comprised of approximately 55.6% senior secured debt investments, 39.4% junior secured debt investments and 5% in equity and equity like securities. As a result, approximately 95% of our total portfolio and 100% of our debt investment is secured by at least a first or second lien with no non-secured debt investments. The majority of our deployed capital is now invested in floating rate investments, which are approximately 70% helps to insulate Harvest Capital's future earnings from the possible negative impact of rising interest rates. In fact, we enjoy upside in net interest margin as interest rate rise. For example, we estimate that NII would increase by slightly over $500,000 with a next 100 basis point increase in LIBOR all of being equal. This equates to approximately $0.08 per share of higher annual earnings. Turning to a few comments regarding the investment environment before handing the call over to Craig, the current state of the markets in the segment in which we primarily compete remains very competitive. Pricing continues to be the primary basis of competition and unfortunately we witnessed further yield compression during the second quarter. It appears to us that the overwhelming majority of the capital pursuing financing opportunities in the lower middle market is not pitching unitranche structures. Further evidence of this is the fact that approximately 80% of our current pipeline involves a unitranche structure. Given where we believe the market is in terms of the credit and economic cycle, this is not in our rationale strategy. In fact, we already began to migrate towards unitranche structures last year. While the end result maybe a modest level of additional portfolio yield compression particularly in the unitranche asset class, we believe the yield tradeoff senior secured in the capital structure should the performance of the portfolio company begin to decline is worth the current margin differential. As is typical, we continue to see a competitiveness gap between sponsored and non-sponsored transactions. However based on our own internal metrics, we believe the gap to have narrowed in the first half of 2017. This is yet another warning sign that too much incremental capital may have entered the debt markets relative to the number of financing opportunities in recent quarters. Looking forward to Q2 -- excuse me, the Q3 and the remainder of the year, our pipeline is solid with the average pipeline of opportunities running roughly 20% above most of 2016. We're currently have one mandate totaling approximately $10 million, which should it close will help offset some of the repayments that have occurred post quarter end. Based on the current pipeline, we're confident in our ability to identify suitable investments to replace the run off going forward. Q3 results will be assisted by the repayments we experienced and we expect to outrun the dividend in the current quarter as a result. The hurdle to replace all the repayments is formidable, but the fee acceleration generated by these repayments will allow us to remain patient and rest assured we'll not compromise credit in order to grow the portfolio back to its prior level and if that it could take the remainder of the year or longer to accomplish that objective. That concludes my formal remarks. I'd like to turn the call over to Craig.

[Craig Kitchin:]

Well, thanks Rich and good morning everyone. Net investment income and core net investment income for the quarter were $2.5 million or $0.39 per share compared to $2.1 million or $0.33 per share in Q2 of 2016. For the year-to-date NII and core NII were $4.8 million or $0.75 versus $4.6 million or $0.74 a year ago. A couple of things to note about earnings for the quarter, number one, as Rich mentioned the growth in NII was largely due to the shut off of incentive fees due to the total return feature in our management agreement. While this is not the preferred way of growing earnings, it is why this was put into the agreement in the first place so the advisor is getting paid at the same time there were losses in the portfolio. Without the total return feature incentive fees would have been about $500,000 or $0.08 per share and NII would have been about $0.31 per share. And number two, there's not much income earned in the quarter related to investment payoffs, several deals that we thought might payoff in Q2, happened in Q3, in fact we had over $27 million of deals payoff so far in Q3, which will accelerate a significant amount of interest in fee income in the third quarter. Much of this could have just to these the way it happened in Q2. Net income was a loss of $1.9 million or $0.29 per share compared to income of $1 million or $0.16 per share in the second quarter of last year. The decrease was driven as Rich mentioned primarily by the depreciation our CRS investment. As of June 30, the fair value of the portfolio was a $137.2 million versus amortized cost of $146.7 million, reflecting $9.5 million of cumulative net unrealized depreciation in the portfolio at the end of the quarter. As of June 30, we had total debt balance of $61.5 million for debt to equity ratio of 72%, up from 60% last quarter, also as of June 30, we had $9.7 million of cash and about $20 million of undrawn capacity on our $55 million credit facility. So with our cash and borrowing capacity and now the large number of repayments so far in Q3, we have enough dry powder to execute the business plan in the short term. Additionally and again I'd point out that we have about $21 million of lower yielding syndicated loans that could be monetized and invested in core deals with higher yields. The syndicated investments had a weighted average effective yield of 12.2% at quarter end. The effective yield of the entire portfolio was 14.6%. I should mention though the two of these deals Novitex and Source HOV were once paid off in July, so liquidity from syndicated deals as of today is approximately $10 million. As of quarter end, our NAV per share was $13. 25, was down $0.64 per share from last quarter, as we had net loss of $0.29 plus $0.34 in dividends paid during the period. And lastly one the dividend, as Rich mentioned, we declared $0.10 special dividend payable in October. We spilled over $0.44 of earnings from 2016 into 2017 and two quarters of this year we've outrun dividend with ordinary earnings by another $0.6. So, we had approximately $0.50 of undistributed tax of earnings to-date and special dividend releases about 20% of that. And with that, I'll turn things back over to Rich.

[Richard Buckanavage:]

Thanks, Craig. We understand that our participants on the call this morning may have some questions. So operator, could you please open up the lines.

[Operator:]

[Operator Instructions] Our first question will come from the line of Brian Hogan with William Blair.

[Brian Hogan:]

I appreciate you are vary through prepared remarks actually that answered a lot of my questions. But I guess can you clarify your ability to grow the portfolio of this year or next year given the pipeline which you said was pretty solid and obviously a lot of repayments coming off? And then I guess I could go through the 10-Q and see the schedule of what schedule to be come to over the next 12 to 18 months? Can you walk through what's coming off in your pipeline?

[Richard Buckanavage:]

Sure, obviously, as we outlined we had a heavy repayments post quarter end some of those were known, some not known. So there is always a few that occur that we are not -- we don’t have a visibility on. Right now I can tell you that we don’t have a lot of visibility on prepayments other than the schedule amortization. We don’t have any significant early repayments that are on our rate on stream currently that not as they can happen. So least in Q3 for the remainder of Q3, we feel good about where we are starting from and then we kind of work from there. We go up hopefully with closing of the mandate, the one mandate that we have and then executing upon a fairly solid pipeline of opportunities. Now, the backdrop to a 20% -- a pipeline that has a 20% increase from the average levels of 2016 is the competitive landscape which as I indicated and it remains very competitive. So we've to taper our enthusiasm for the rest of the year with the marketplace and so we'll continue to fight battles, but we're starting at least with a pipeline of opportunities and the quality of those opportunities is pretty solid as well. So, we feel like we can at least make a lot of headways in the remainder of the year to replace the $27.7 million. But as I said in my prepared remarks, no guarantees that we can do it by quarter end and it make take into the early parts of 2018. But that's really the dynamics today where we see our ability I think it's going to unitranche that seems to be the prevalent strategy of choice today, both from the capital that's in the marketplace and it seems from the actual borrowers themselves, seem to prefer a more simplistic unitranche approach, that will have some negative consequences for the overall portfolio yield. But not significant and certainly not significant to offset the benefits of being senior secured in the cap structure.

[Brian Hogan:]

That actually led to my -- my next question was the yield outlook, and given the shift to little bit to more unitranche in this -- what do you see as being the overall yield compression? In order of magnitude, is it 30 basis points or maybe what's, can you kind of?

[Richard Buckanavage:]

Yes, I think that's directionally right Ryan, if you look at our cash yield and generally unitranche in essence do not have a pick component. I mean one or two maybe do but largely do not, but if you look at the end of the year at '16, I think we had a cash coupon about 12.3, through June we had a cash coupon of 11.4. I would expect the cash component of that -- of our portfolio yield to come down by about 50 basis points, so maybe that at 10.9ish level.

[Brian Hogan:]

And then can you walk through the other and I guess two non-accruals besides CRS?

[Richard Buckanavage:]

Yes, Peekay acquisition that's been on non-accrual for several quarters, now it's been written down to zero, I think for two quarters. That ironically was a financing that we felt less optimistic about and indicated that in prior earnings calls. But I don't think our perception of that investment has changed much in last couple of quarters, not much movement one way or the other. We've written it down to zero based on probability weighing multiple scenarios, many of which result in us receiving little if any recovery on our $2 million investment.

[Brian Hogan:]

And the IAG engine has it?

[Richard Buckanavage:]

Right, that's a revenue linked security, so it kind of operates like an equity feature, like almost like a….

[Craig Kitchin:]

It is an equity kicker on that, IAG term loan, but we accounted for it is a beneficial interest and is securitized asset. And so, we account for it with the effective yield method and like Rich said in the prepared comments, we actually think that the recovery on our share of the inventory sales going forward probably going to be intact, but our partner in the deal just got out of the gates slowly and didn’t meet expected inventory sales. And our cash flow expectations were met for the first couple of quarters out of the gate. So, we decided to put it on nonaccrual status and we debated taking it back off this quarter but didn’t do that yet, but that could happen next quarter.

[Richard Buckanavage:]

Brian, royalty was the word I was searching for there. It's structured very similar to like royalty, but again we accounted as that -- as it looks to more like a debt investment. But it is primarily kind of an equity oriented investment.

[Brian Hogan:]

Can you elaborate a little bit on the CRS Reprocessing like what went wrong outside of I'd say not be able payoff on June 30 and what's the outlook?

[Richard Buckanavage:]

Yes, again in a distressed investment, we generally will go through multiple scenarios where we probability weigh those scenario. And over the prior quarters while there was an increasing level of uncertainty with regards to the outcome for CRS, the waiting on certain alternatives or outcomes did have some waiting too them where there was an expected recovery on our investment. As additional time went by and the market did not recover for their underlying products, we began to wait other scenarios more heavily. I think you heard me to allude in the prior two earnings calls working collaboratively with other parts of the capital structure that collaboration as evaporated. So we began to wait some of the scenarios where we received little, if any recovery on our investment and of course you come with a fair value that’s closer to zero, if not zero then in prior quarters, so really just additional uncertainty and really now every layer of the capital structure working independently in their own best interest. So just establish just the outcome and that’s a really kind of devolved over this quarter.

[Brian Hogan:]

And my last question for now, any change at the SBA on your front or just into the bigger picture perspective as into their activity and then we SBIC license.

[Richard Buckanavage:]

There has not been Brian although we even if there was I probably wouldn’t tell you probably differ to a point and time when we feel like we have a green light letter in hand or license, but we are not pursued that much of that initiatives. We believe that there was somewhat a negative bias towards the BDC space down in Washington for some time. We are not sure where that stands today, but hopefully that changes and other BDCs, excluding one that already have BDC licenses because they seem to be still waiving those through given the increase in the maximum leverage. But we haven’t really seen new BDCs obtained green light letters.

[Operator:]

Our next question will come from the line of Brian Lynch with KBW.

[Brian Lynch:]

I just have a couple of questions. You guys obviously have a lot of prepayments coming third quarter. Can you quantify the amount of prepayment fees you've received quarter-to-date?

[Craig Kitchin:]

Brian, this is Craig. It's a mixture of prepayment fees and there'll be some acceleration of deferred fees that show up on the interest income line, but it'll be in the range of $400,000 of kind of accelerated the non-recurring income.

[Brian Lynch:]

And then just a clarification for something you said in your prepared remarks. Did you say you have one mandate quarter-to-date totaling 10 million?

[Richard Buckanavage:]

That's correct Ryan.

[Brian Lynch:]

And then do you guys expect to receive an incentive fee -- full incentive fee, partial incentive fee or no incentive fee in the third quarter?

[Craig Kitchin:]

Well, the last -- the first quarter of this year we kind of ran past all of the stuff that happened in the first year after the IPO. So all the trailing three year issues went away and we got back to sort of neutral. So, to the extent that we had more depreciation income in Q2, we'll have to make that up in Q3 before their incentive fees paid. So, whatever the net loss was for Q2 has to be made up before incentive fees are paid. So a long way of saying, it'll -- unless, there's appreciation in the portfolio it'll be haircut somewhat in Q3.

[Brian Lynch:]

And then just one last one, what sort of pricing are you seeing on new unitranche loans in the market today? And how far -- what sort of leverage are these new unitranche loans? How deep in the capital structure they're going?

[Richard Buckanavage:]

The unitranche pricing that we see and I'm going to quote you what we're seeing, I'm not going to quote you what we're doing. For two reasons, one we don't -- we won't -- we can't make -- we can't meet the dividend at the lower end. And two, I don't want to tell the marketplace exactly what our pricing is. So I'll give you a range that we see and I would say it's probably in the L-8.5 to L-10.5 range. And leverage as I said in my comments, leverage is not getting pushed at all, I mean if anything it's maybe even dropped a little bit. But leverage has not been -- for at least in the lower middle markets this year, leverage has not been a basis of competition; it's really been pricing. And if you look at some of the BDCs, they've kind of changed direction to go unitranche and certainly all of the new capital that we've seen coming to the marketplace, everybody is unitranche, every single group that I'm aware of in 2017 other than maybe a couple of private SBIC funds. But all of the private credit funds that have entered the market are all doing unitranche and so -- and they maybe going lower than that, some of the bigger ones as certainly I think probably doing something that's closer to 7.5. But we probably don't even see those transactions; one because it's lower than we could ever imagine; and then two, largely going to be bigger deals then we could be competitive in.

[Brian Lynch:]

So would you say, it sounds like it's combination, correct me if I'm wrong, it's a combination of new players coming into the market and putting pricing pressure on unitranche loans as well as existing players that were in the lower middle market, that has now maybe shifted their strategy from second lien and sub-debt to more new unitranche solutions. Is that fair or is that a combination of both of two factors that's putting pressure on unitranche?

[Richard Buckanavage:]

Yes, that's a fair statement Ryan.

[Operator:]

[Operation Instructions] And it appears we have no questions in the queue. I'll turn the conference back over to Mr. Buckanavage for closing comments.

[Richard Buckanavage:]

Thank you, everyone for participating in our call this morning. We look forward to talking to you in a couple of months regarding our Q3 results. Have a good day.

[Operator:]

Once again, we would like to thank you for participating on today's conference call. You may now disconnect.