Harvest Capital Credit Corporation
Q3 2017 Earnings Call Transcript

Published: 7 Nov 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 Corporation Third Quarter Earnings 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] Thank you. Mr. Richard Buckanavage, you may begin your conference call.

[Richard Buckanavage:]

Thank you. Good morning, everyone and thank you for participating in this conference call to discuss our financial results for the quarter ended September 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 the 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:]

Thank you, Craig. For the quarter ended September 30, 2017, we generated net investment income and core net investment income of $0.24 per share and $0.36 per share respectively. Core NII which we feel is the best measure of sustainable profitability fully covered our dividend of $0.34 per share. It is also worth noting that at September 30 but after giving effect to the special dividend paid in October, we continue to maintain $0.23 per share of spillover income with which to support future dividends. The overall performance of the portfolio remains at an acceptable range and despite a substantially lower portfolio in the third quarter due to several unplanned exits, we continue to cover the dividend. The deployment environment remains very competitive, but rest assured, we will not compromise our underwriting standards or stretch for yield in this market. Although we have mandated transaction scheduled to close in the fourth quarter, future growth is likely muted and this management team and our board is completely comfortable with slower or no portfolio growth should this environment persist. Lastly, I want to recognize the positive outcome we achieved in the public debt markets in August. We successfully completed a $28.75 million unsecured note offering inclusive of the overall allotment option granted to the underwriters at an interest rate of [indiscernible] which is nearly a full percentage point lower than our 7% notes issued in 2015, and at the same time extended the maturity of our fixed rate liabilities by almost 2.5 years. While on accretive transaction over the life of the note offering, we incurred early debt extinguishment charges and other note related expenses this quarter which were the drivers of the difference between net investment income of $0.24 per share and core net investment income of $0.36 per share. The third quarter was an extremely active quarter for Harvest in terms of repayments. We exited seven investments and wrote-off one additional investment during the quarter totaling approximately $38.7 million. This level of repayments far outpaced the three deployment transactions completed during the quarter that totaled approximately $11.2 million. After gaining effect in the most recent exits including those completed subsequent to quarter end, we now have 38 investment realizations inception to-date. Excluding temporary place holder investments, we have experienced a weighted average internal rate of return of 17%, an MOIC of 1.4 times continuing our track record of generating equity-like returns with investments in debt securities. In terms of new financing completed during the quarter, two were entirely new transactions totaling $10.8 million combined with one follow-on investment at an existing portfolio company totaling $400,000. The allocation of the deployed capital by asset class was as follows; $3.7 million in senior secured debt, $6.5 million in subordinated debt, and $1 million in equity. Of the $10.2 million in debt investments completed during the quarter, $9.5 million were fixed rate and $700,000 were in floating rate structures. Subsequent to quarter end, we closed two additional financings totaling $4.2 million comprised of $3.7 million in debt and $500,000 in equity capital. Both transactions involved follow-on investments in existing portfolio companies and both debt investments were in senior secured asset class and both were in floating rate pricing structures. From a risk perspective, the portfolio continues to exhibit acceptable results with a weighted average risk rating of 2.02 at 9/30/2017, a decrease from 2.05 at prior quarter end. As of 9/30, we had one revenue linked security on non-accrual status that represents less than 1% of the total portfolio at cost and on a fair value basis. However, based on recent developments we believe there is likely that this investment is returned to accrual status in the fourth quarter. We continue to maintain prudent diversification across the portfolio. However, due to the significant decline in the portfolio during the quarter, our Top 5 abagore concentration increased to 40.4% from 33.2% at prior quarter end. And the Top 10 abagore concentration increased as well from 54.4% at 6/30 to 62.1% at 9/30. At quarter end 9/30/2017, our portfolio was comprised of approximately 52.1% senior secured debt investments, 42.2% junior secured debt investments, and 5.7% in equity and equity-related securities. As a result, approximately 95% of our portfolio is secured by a first or second lien with no unsecured debt investments. Approximately 57% of our deployed capital is investment in floating rate investments. While decline from prior quarters due to the composition of the A-exits in Q3, this level of floating rate investments continues to shield Harvest Capital's future earnings from the possible negative impact of rising interest rates. And we will continue to experience upside in net interest margin as rates rise. For example, we estimate that net investment income would increase by approximately $528,000 with the next 100 basis point increase in LIBOR, all else being equal. This equates to approximately $0.08 per share of higher annual earnings. It's worth noting that after giving effect to the two transactions closed subsequent to quarter end, floating rate investments currently represent nearly 60% of the total portfolio. 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, however amortization holidays and overly back-ended amortization are also becoming competitive features in the unitranche market. Our third quarters deployment notwithstanding the overwhelming majority of the recent capital request we received involved unitranche opportunities. As stated in prior quarters, all else being equal, we look to overweight in the unitranche assets class for the foreseeable future. While we firmly believe in this strategy, given the first priority aligned [ph] position and the enhanced rights and remedies afforded a senior debt provider, the strategy comes at a cost which is yield; the end result maybe a modest level of additional portfolio yield compression and Q4, and into early 2018. New entrants to the lower middle market or larger opportunistic firms entering into lower middle market in search of yield may win mandates with lower pricing and over-borrower friendly structures. However, our platform continues to identify opportunities with organizations that value execution certainty and understand the value of a good partner, not only at the closing table but post-close as well. Our deep relationship base is producing a solid pipeline of opportunities, while down from the earlier part of 2017, the pipeline remains approximately 15% above average 2016 levels. And the credit quality of the opportunities is solid. We currently have two mandates totaling approximately $14 million, both of which are scheduled to close in the fourth quarter. Should they close along with transactions already completed during the quarter will offset approximately 65% of the portfolio run-off experienced in the third quarter. Lastly, before handing the call over to Craig, I would like to update everyone on the progress we have made in transitioning the accounting and administrative functions currently being provided by our affiliate JMP credit to our New York City office. After careful analysis, we have concluded that three individuals are required to transition these activities. To-date, two of these hires are complete. We have brought onboard, Bill Alvarez, the eventual successor to Craig as CFO; and Matt Rosencrans [ph] who will assume the role of Head, Administration. One additional individual in the accounting area will be hired shortly which in conjunction with the outsourcing of our middle office will complete the team necessary for this change over. With all of the pieces nearly in place, we have insured an orderly hand-off between JMP Credit and our internal staff. Credit our relationship with JMP and the multi-quarter transition runway they provided us to increase the likelihood of this successful outcome for shareholders. While some duplicative cost exist to run both teams side-by-side during the initial phases of the transition, we believe this approach was in shareholders' best interests and these redundant costs are only temporary. Our goal at this point is to run the redundant platforms through year end with a hand-off to occur in the first quarter of 2018. That concludes my formal remarks. I'll turn the call over to Craig.

[Craig Kitchin:]

Well, thanks Rich and good morning, everyone. Net investment income for the quarter was $1.6 million or $0.24 per share compared to $3.0 million or $0.47 per share in the third quarter a year ago. Core net investment income was $2.3 million or $0.36 per share compared to $3 million or $0.47 per share a year ago. In calculating core NII, we added back $737,000 of onetime costs associated with the refinancing of our baby-bonds during the quarter. A couple of other things to point out about earnings for the quarter; number one, we had over $30 million of performing loans pay-off during the period. This helps through the fee and other income line items during the quarter but hurt run rate interest income. So we had fewer assets that work and the loans that paid off had an effective yield of 15.6%. Losing them put pressure on the weighted average portfolio yield which fell about 80 basis points during the quarter. And number two, we had about $0.03 per share of additional overhead cost this quarter related to the transition of the administrator from Atlanta to New York. So in spite of these two headwinds, our core NII was still $0.02 per share above the regular dividend of $0.34 per share. And lastly, I'd point out mostly for comparison purposes, that in the third quarter last year we brought the Fox rented car investment back on accrual status and recognized about $800,000 or $0.13 per share of income along with that. That was a major driver of last year's large NII number. Net income was a loss of $300,000 or $0.05 per share compared to income of $2.4 million or $0.38 per share in the third quarter of last year. The decrease was driven primarily by lower NII and net capital losses in the portfolio. As of September 30, 2017, the fair value of the portfolio was a $113.5 million versus amortized cost of $116.6 million, reflecting $3.1 million of net depreciation in the portfolio. At September 30, we had total debt balance of $32.5 million for a debt-to-equity ratio of 39%, down from 72% last quarter, the large decrease is a result of all the payouts we had in the period. I mean earlier, as Rich did, that we refinanced the company's baby-bonds during the quarter, this transaction reduced the coupon from 7% to 6.78% [ph] and extended the life for another 2.5 years. The new issue has essentially the same other features as the bonds we paid off, they are interest only, they are fixed rate and they have very few covenants. At September 30, we had $2.5 million in cash and about $50 million of undrawn capacity on our $55 million credit facility. So with our cash and borrowing capacity we have a decent amount of liquidity today. Additionally, we have about $10 million of lower yielding syndicated loans that could be sold and invested in core deals with higher yields. These syndicated assets had a weighted average yield of 11.8% at quarter end, effective yield of the entire portfolio was 13.8%. At quarter end, NAV per share was $12.86, down $0.39 per share from last quarter as we had a net loss of $0.05 per share plus the $0.34 per share in dividends that were paid during the period. And with that, I'll turn things back over to Rich.

[Richard Buckanavage:]

Thanks, Craig. We understand that there may be some questions from those participating on the call this morning. So operator, could you please open the lines up for any questions our participants may have.

[Operator:]

[Operator Instructions] And our first question comes from the line of Brian Hogan.

[Brian Hogan:]

Good morning. I guess a quick question on expenses. I was at the grant to go upto 1.4 for the year; I guess my question is, is that a run rate for your administrative expenses or as we think about 1.2 going forward?

[Craig Kitchin:]

The additional $195,000 we think is a one-time expense for the year that increased the 2017 cap to 1.4, so I would expect it to go back to the $300,000 run rate next quarter.

[Richard Buckanavage:]

Brian, just to add to that; that's the redundant cost that I referred to in my comments regarding running the platform side-by-side that $195,000 is that cost, so it is a temporary increase just for this period of time.

[Brian Hogan:]

Okay, that's helpful. And then I guess, how should we think about the general administrative expenses; they kind of bounce around quite a bit; I guess what's the best way to think about this?

[Craig Kitchin:]

I think a couple of things I'd say about that. In 2017 we've got additional G&A costs getting ready to be stocks [ph] complaint in 2018. So there is a couple of pennies a share for the year in consulting cost that are helping us get ready for the year -- next year when we've got to be socks [ph] compliant. In the third quarter we also had a little over $0.01 a share in previously capitalized offering cost related to our self-registration statement that expired that we wrote off. I think that will be relatively non-recurring although we do have a shelf that's current today. So it might happen again in the future at some point. So this year is more expensive for a couple of reasons. And then overall, I'd say because we've done our ATM program and we've updated the shelf a couple of times this year, we've just had higher legal and accounting expenses that got expense rather than capitalized.

[Brian Hogan:]

Sure. I appreciate that. And then the last one on expenses; the incentive management fees, second quarter in a row you didn't have any -- the first quarter this year was very light, you may obviously do the math based on this going forward but what is your expectations for incentive fees going forward?

[Craig Kitchin:]

In the third quarter, the company didn't hit the 8% hurdle, so it wasn't due to the total return look back but it only didn't hit the hurdle because of the one-time cost we had related to the bond redemption. I think going forward you should expect that we will head the incentive fee hurdle and then it's just a matter of overcoming depreciation and we've got about $1.8 million of net depreciation to overcome first before the manager starts getting paid incentive fees again.

[Brian Hogan:]

Okay, that's quite helpful. And then, the last one for me at the moment is that you mentioned the pipeline at $14 million across two transactions mandate just to say -- here in fourth quarter, whether the yields on those, I didn't catch that if you did mention it, sorry. And then remember, you're like what do you expect for the overall portfolio yield given the competitive environment and what have you?

[Richard Buckanavage:]

Brian, I did not mention the yields. I don't combine bases since they are relatively similar in size, it's kind of in that call it 11% to 12% range for both of those investments. They are both unitranche investments, so they are on the lower end for us if you look at that compared to the portfolio. And based on those investments and others that we've made, we -- again, have in over-waiting the inner-tranche asset class; so we do see a little portfolio compression here in the fourth quarter and likely into the first quarter. While it's been a very competitive year, I would say that we're not -- I haven't seen any further price compression that's kind of occurred in the first two quarters and now it's going to settle in at a fairly aggressive level but we haven't seen any further compression here in the early stages of Q4 and late Q3. So hopefully, whatever compression has occurred this year is that. And again, based on what we've booked this year, I would see a little bit more compression there, maybe 25 basis points but not much more than that.

[Brian Hogan:]

Interesting. Are those fixed or floating?

[Richard Buckanavage:]

One of those is fixed and one is floating.

[Brian Hogan:]

All right. And then, I guess truly one last one. Do you expecting to roll a portfolio next year; I haven't done the math yet to go look to that what do you expect to run-off but from a pure scheduling standpoint but -- what is it that you've mentioned that being very competitive and you're okay with very slow growth and your comments in your prepared remarks, I guess. But what are your expectations at the moment, whether to grow the portfolio next year?

[Richard Buckanavage:]

Well, certainly the goal is to grow the portfolio but only to do that to the extent the market allows us to invest in risk-adjusted attractive opportunities and those may present themselves and they may not. So certainly the goal is to find additional opportunities to deploy capital. At this point, given the two transactions that closed, if they close in the fourth quarter, you know, we don't even get back to where we were couple of quarters ago, prior to that, the big repayments between second and third quarter. So I think certainly our goal is to get back to where we were and to replace the Q3 run-off. And then certainly grow from there. Obviously, as why know, we came from where we are -- from a capital perspective, there is not significant growth even if the opportunities are there. We're not trading at a level where we would be able to tap the public equity market. So I think under -- probably more scenarios than not, growth is going to be muted in 2018 but again, I think there are some growth -- certainly growth objectives on our part there and certainly capital to grow but within a pretty narrow range.

[Brian Hogan:]

All right, thank you.

[Operator:]

[Operator Instructions] Your next question comes from the line of Ryan Lynch.

[Ryan Lynch:]

Good afternoon, and thanks for taking my questions. I wanted to have a conversation on the dividend; so this quarter core earnings more than cover the dividend, if you split out the onetime expenses of refinancing [ph] but if I look at longer term, your dividend yield right now is about 10.5%, ROE on your book value. And in -- you guys are moving up the capital structure, moving the higher quality loans that kind of put pressure on your portfolio yields and then additionally, in the near to medium term it sounds like portfolio overall is going to be muted which is fine; I know you guys have some spillover income to whether that -- if a guy is put under on the dividend for period time, our portfolio growth is slower or muted. That's fine but just kind of the longer term outlook. Is it reasonable to anticipate and you guys are expected to be able to generate a 10.25% operating ROE in an environment that really very tough without taking on access credit risk.

[Richard Buckanavage:]

Ryan, those are exactly the conversations we're having internally which is just trying to look at the cash flow generation capability of the portfolio and trend that out over the next couple of quarters and trying to make sure assumptions with regards to the marketplace we're going to be confronted with. Right now we're expecting very little improvement in the deployment environment which obviously, negatively impacts the 10.5% sustainability but at this point we're not ready to relook at our dividend, I think we've got this a little over income that provides us with a little bit of patience in the short-term and as events unfold, we may change that perspective but I think that right now, we feel like the portfolio is performing very well, obviously we exited a couple of tougher investments this past quarter which losses with virtually no non-accrual loans. And so we feel like we're in a good position portfolio-wise. We don’t need to grow substantially to grow into a dividend yield and we have that patience in the form of the spillover. But again, if the market continues to get even more competitive that’s certainly best decision at the board level could possibly change. But we feel good about where we are and we are going to see whether 2018 brings a different deployment environment. We know that this environment can’t last forever. It’s at levels that aren’t sustainable this is pretty much indicative of a late cycle market where pricing is getting driven down, structures are becoming overly loose. Covenant deals are not that prevalent in our market. We’re even hearing some things that people are taking covenants out. But certainly, the amortization holidays or 100% balloon financing structures are typical of the late cycle and we think it eventually will change. But again, if it does persist for a pro-longed period, we will revisit our decision on where we are from a dividend level and we do that every quarter. Obviously, we have this exact conversation every quarter.

[Ryan Lynch:]

Okay. That’s helpful discussion. And I do want to be clear, I do think that showing patience and the ability to slow down portfolio growth or actually stop portfolio growth in maybe a frothy environment not reaching for yield and taking on undue credit risk in order to maintain portfolio yield is the absolute right move to make. So, I am happy for you to say that. I did have one other question on the incentive fees and just kind of fees in general. So, there is a small incentive paid in the first quarter, the last two quarters no incentive fee was repaid depending on what you guys do, I don’t have an incentive fee being paid in the fourth quarter. So, if that’s the case I mean there are very little incentive fees depending on what you guys – fourth quarter shapes out to be paid this year? I just want to know, I mean obviously, you guys have to have the conversation to keep investment professionals at the firm. So, how are you guys able to not lose investment professionals in a time where you guys incentive fees are very low?

[Richard Buckanavage:]

That’s a great question Ryan and it’s one at top of mind for obvious reasons. We continued to generate enough in fees that come into the manager to support the staff we have and we don’t have that big of a staff. We tend to always under-hire quite frankly given our needs and only hire when we are almost -- when we exceed the six portfolio companies per investment professional, a metric that we use internally. So I think the good news is, we never get too far out over the skies and secondarily, we're just not that big and if there is a safety valve and that becomes the onus of the managers which is the senior management team at JMP that we will take less in compensation for a period of time to support the important staff that we maintain to manage the portfolio; even if there is no growth, we need those investment professionals to help manage which is a fairly decent size portfolio, 33 portfolio companies. So they are an important part of our success here and we'll compensate those people based on the market compensation to maintain that level of staff.

[Ryan Lynch:]

Okay, thank you. That's all for me. Thank you for taking my questions.

[Operator:]

And your next question comes from the line of William James [ph].

[Unidentified Analyst:]

Craig, when I read the house proposed text, and I realize that decisions are being speculative but it says that if interest expense is 30% of EBITDA, any amount over that will be suspended or negated. And so when I run the numbers on a debt-to-EBITDA ratio, it looks like 3.5 times and up, falls in the category of interest suspension or denial and it looks like that could cause free cash flow issues. And so I'm just wondering if you guys are having discussions or thoughts with regards to your portfolio companies as to how either sponsors or new equity or new preferred stock, how that will be adjusted if the house bill goes forward?

[Craig Kitchin:]

Rich, you're going to take that one?

[Richard Buckanavage:]

Good question, and we actually have had this conversation and the -- I would point out that majority of our financings, at least initially go on -- the attachment point is actually under 3.5 times and that's really indicative of the lower middle market and I'm not saying we don't have investments that are in excess of that, we have a couple but almost no -- none of our investments other than the larger temporary placeholder investments that we do from time to time in the syndicated loan market, those might be in excess of 4 times but almost none of our core lower middle market deals are in excess of 4 times and many are well below 3.5 times. And as we look to do more unitranche financing, that's even going to be nor the case, again as we deemphasize subordinated debt investments. So if there is a little bit of over-edge, it's very dominimus [ph] and like I said, I don't know the number on top of my head but I can tell you that the weighted average going in leverage of multiple is under 3.5 times. So I think we would be somewhat shield from that impact if in fact it gets passed as you alluded to.

[Unidentified Analyst:]

Well, that's really comforting and maybe that will provide some interest rate spread and going forward as this plays out for you guys. Thanks a lot.

[Richard Buckanavage:]

You're welcome.

[Operator:]

[Operator Instructions] And there are no further questions at this time.

[Richard Buckanavage:]

Thank you, everyone for participating in the call and we look forward to catching up in the next couple of months to talk about Q4 and full year 2017. Thanks again.

[Operator:]

This concludes today's conference call. You may now disconnect.