Harvest Capital Credit Corporation
Q2 2016 Earnings Call Transcript

Published: 9 Aug 2016

[Operator:]

Good morning. My name is Holly and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Harvest Capital Credit Quarter Two 2016 Earnings Conference Call. [Operator Instructions]. I'll now turn the conference over to Richard Buckanavage, CEO. 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, 2016. I'm joined today by our Chief Financial Officer, Craig Kitchin. Before we start the 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 statements made herein.

[Richard Buckanavage:]

Thank you, Craig. As is typical during our earnings call, I will address a few high-level topics before turning the call back over to Craig who will walk you through our financial results in greater detail. Overall, I'm pleased with the performance of the business. With $0.33 per share of core net investment income, when combined with core net investment income of $0.41 per share in the first quarter, Harvest Capital continues to out earn the distribution being paid to shareholders through the first half of 2016. These results, combined with our spillover income of $0.22 per share from fiscal year 2015, should provide shareholders with confidence in our ability to at least maintain the current dividend payment level for the remainder of the year. The portfolio continues to perform acceptably. While we did have some NAV degradation during the quarter, the majority of the portfolio depreciation was attributable to three investments. With a weighted average risk rating at quarter-end of 2.01, we witnessed a slight improvement from 2.02 weighted average risk rating at the prior quarter-end. Q2 2016 was a slow quarter for us in terms of capital deployment. We closed two follow-on term loan investments in an existing portfolio company, WBL SPE II, totaling $2.5 million. The yield on these two follow-on investments was 14.5%. While we didn't experience any full exits during the quarter, we did see three unscheduled partial prepayments during the quarter that along with scheduled amortization, resulted in a modest portfolio decline. Subsequent to quarter-end, we sold our Class A equity units in Optimal Blue, LLC totaling approximately $800,000. This realization compares favorably to the fair value of these equity units at March quarter-end. The internal rate of return on this equity investment was 85.5% and when combined with our previous debt investment in Optimal Blue which was exited in Q1, we realized a 20.8% internal rate of return on our overall investment. The Optimal Blue exit represents our 21st exit since inception and the average internal rate of return on these 21 investments is 20.6%. We continue to maintain prudent diversification across the portfolio. Our top 5 obligor concentration remained stable at 32.8% from 33% at prior quarter-end and the top 10 obligor concentration increased only modestly from 53.6% at 03/31/16 to 54.2% at 06/30/16. We remain committed to prudent industry diversification as well. We continue to have no direct exposure to the oil and gas sector which has served us well over the past several quarters. However, as stated in prior quarters, the underlying portfolio in our lone investment in CLO equity does have exposure to the oil and gas industry, but it is an immaterial amount and the CLO itself is in the wind-down phase. So, we would expect this small exposure to continue to decline over time. At June 30, our portfolio was comprised of approximately 50% senior secured debt investments, 45.5% junior secured debt investments and 4.5% in equity and equity-like securities. As a result, over 95% of our total portfolio and 100% of our debt investments are secured by at least a first or second lien with no unsecured debt investments. The portfolio continues to have the majority of its assets maintained in floating rate investments which at approximately 65%, helps to insulate Harvest's future earnings from a possible negative impact of rising interest rates. In fact, we will enjoy upside in net interest margin as interest rates rise. From a credit perspective, the portfolio continues to perform acceptably with a weighted average risk rating of 2.01. As of 06/30/16, we had two loans on non-accrual status. The new non-accrual loan is Fox Rent A Car. While the company's financial performance has been acceptable, the senior lenders to Fox, we believe, acted hastily to what we would characterize as a technical default. Despite having lowered the fair value of this investment given the heightened level of risk associated with our position in the capital structure, we're working closely with management toward an acceptable solution for all parties involved and fully expect to receive all contractual cash flows due to Harvest, including both principal and interest. Current state of the credit markets and the segment in which we primarily compete continues to be very competitive, particularly for transactions involving a private equity fund. While we remain committed to the sponsor space, we anticipate deploying more capital in non-sponsored transactions in the short term where there are fewer competitors, better yields and more reasonable capital structures. We're confident in our ability to identify acceptable investment opportunities in the non-sponsored sector. However, with overall M&A down over 50% from the same period in 2015, the reality is that we're just seeing fewer opportunities. If this situation persists, we would expect deployment in the second half of the year to be lower than the approximately $24 million of investments closed in the first half of 2016. That concludes my formal remarks. So, I'll now turn the call over to Craig.

[Craig Kitchin:]

Thanks, Rich and good morning, everyone. Net investment income and core net investment income for the quarter were $2.1 million or $0.33 per share, compared to $2.1 million or $0.33 per share in the second quarter of 2015. A couple of things to note about NII and core NII for the quarter, number one, as Rich mentioned, we put Fox Rent A Car on non-accrual which reduced earnings by $0.05 per share. Although we think there is a likely full recovery on this deal, the fact that the interest has been blocked since the beginning of the quarter and that the blockage might continue for a while, we decided to take a more cautious stance. And number two, the three-year total return look-back feature in our management agreement came into play for the first time in the second quarter and reduced incentive fee expense by $559,000 or $0.025 per share. The look-back feature requires that no more than 20% of the last three years' cumulative net income can be paid to the manager in incentive fees over that same period of time. So, portfolio depreciation and capital losses have an impact on the NII incentive fee. The reason that they haven't impacted up until now is that there was a large cushion built in the first year following the IPO when incentive fees were either not earned or were waived. Net income for the quarter was $1 million or $0.16 per share, compared to net income of $3.2 million or $0.51 per share in the second quarter of last year. The decrease was driven by $1.1 million in unrealized and realized losses this quarter, compared to $1.1 million in realized and unrealized gains in the quarter last year. PIK income represented 8.5% of total interest income in the second quarter, compared to 6.8% of interest income in Q2 of last year. For the last couple of years, the percentage of our income that has been PIK has been on the decline. It went up, however, this quarter due to an amendment on our CRS debt investment which increased our interest rate from 5% cash to 5% cash plus 5% PIK. Overall, though, we still have a relatively small percentage of our total income that is PIK. We were still below our target leverage level at the end of the quarter. We had total debt of $63 million at June 30 for a debt-to-equity ratio of 73% which is essentially flat to last quarter. As of June 30, the fair value of the portfolio was $146.3 million versus amortized cost of $150.4 million, reflecting $4.1 million of net depreciation in the portfolio at the end of the quarter. As of quarter-end, we had $2.8 million in cash and $19.5 million available on our $55 million facility. So, with our cash and borrowing capacity, we have enough dry powder to execute the business plan in the short term. Additionally, I would note that we have about $27 million of lower yielding syndicated loans that could be monetized and invested in core deals with higher yields. These syndicated investments had a weighted average effective yield of 11.3% at quarter-end. At June 30, NAV was $13.71, down $0.19 from last quarter as we had net income of $0.16 offset by $0.34 in dividends paid. One other thing that I will mention as Rich did is that we carried over approximately $0.22 per share in undistributed 2015 taxable earnings into 2016 that will be deemed to be paid out in the third quarter of this year but as part of our regular monthly distributions. We did the same thing last year with carryover earnings, paying them out as part of our regular monthly dividends instead of declaring a special dividend. This should give investors a degree of comfort as to the sustainability of current dividend levels. And lastly, I would mention that we began our share buyback program in the second quarter. However, the stock price improved enough and quickly enough that we were only able to buy 5,500 shares at or below our target price. So, we will continue to monitor and be looking to repurchase shares should we conclude that the use of our capital for this purpose is the highest and best use as compared to other alternatives. And with that, I'll turn things back to Rich.

[Richard Buckanavage:]

Thanks, Craig. Thank you everyone for listening in this morning. We understand that you may have some questions for us. 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 Ryan Lynch with KBW.

[Ryan Lynch:]

First question just goes around maybe some portfolio yield compression. We've seen some yield compression in you guys' portfolio as well as most BDCs. Is that more being driven by just slow deal activity and deal flow in you guys' normal channels or are you guys seeing increased competition as we're seeing yields fall kind of around the world as well as in the U.S.? Are you seeing more competitors try to dig down into the lower-middle market to get some of these higher yielding loans? So basically, are you seeing yield compression because there's increased competition or is it because there is just not a lot of deal flow, lot of money chasing after not a lot of deal flow going on?

[Richard Buckanavage:]

Brian, for us, if I kind of rewind back a year or 18 months, as some of our yield compression overall has been, as we migrated the portfolio from largely a junior capital portfolio to include the unit tranche asset class which by definition, carries a lower yield. That's largely been complete. And so, what you're seeing here in the last quarter to let's call it a year really is the competitive forces at play. It's interesting, we did see some yield expansion -- at least we thought we were seeing it in the fourth quarter and we got into the early part of 2016 and the market got very competitive very quickly, we believe, driven by the lack of just sheer deal volume across the overall spectrum. I'm not aware of that many bigger players coming into the lower-middle market. I think that did happen in 2015, maybe even a little in 2014. We're not seeing an acceleration of that in 2016. I think it's just really a function of few overall opportunities and the same number of people chasing those opportunities, creating a fairly competitive environment.

[Ryan Lynch:]

And then, you mentioned, potentially over the next quarter or so, looking to put some more money or maybe just seeing more opportunities or deal flow in the non-sponsored transactions. Given where we're -- I guess, nobody really knows where we're from a credit cycle turn point, but just given where we're in the marketplace in the credit cycle, why do you think it's more appropriate to be moving into maybe more non-sponsored deals versus -- which I guess could have some better deals, but don't have the backing of a sponsor who can, if things go wrong, can contribute more capital and kind of help that investment out, so just why have this continued focus in non-sponsored transactions at this point in the credit cycle?

[Richard Buckanavage:]

Keep in mind, Ryan, about 40% of our portfolio is already non-sponsored, so this isn't a large shift for us. It's really just a recognition of the competitive landscape. So, we're competing against one or two players in the non-sponsored space and we're competing against fix or six or seven players in the sponsored space. It's really just math. It just comes down to fewer competitors. We think we'll have more success there. But we recognize certainly the dynamic you just outlined which is we don't have a sponsor, we need to be a little bit more careful in the non-sponsored space. It needs to be an industry where we have some expertise or we have a relationship with someone who does have expertise that we can parachute in if in fact that company would get into some financial difficulties. So, we're cognizant of the dynamics between the sponsored and the non-sponsored deal, but again, not a huge shift here just recognizing the lay of the land as it stands today.

[Ryan Lynch:]

And then one question, maybe difficult for you guys to answer, but still on Fox Rent A Car, as you guys worked it that alone, do you guys have any sort of time frame whether you guys hope to get some sort of resolution, whether you guys are going to reposition the balance sheet or just kind of work that deal out to get that back? You saw a portion of it on accrual status. Do you have any sort of time frame of when you guys hope to work that out? Is that a third quarter seeing or just maybe second half of 2016 event or further along than that even?

[Richard Buckanavage:]

Well, I think the safest response to that is the second half of 2016, obviously because that gives us the flexibility, but I will say this, we're working very collaboratively with management and ownership and we're now finally actually starting to have those conversations in a tri-party fashion which includes the senior lending group. And we think we've got some -- while we've made some progress, we think we've got something that's close to getting consensus around the table. That's critical for having an outcome that is something that is going to be favorable for us. Everyone working in tandem towards a common solution, you don't get everything you want, but we have a seat at the table, we do have a second lien in that situation and this is a sizable business and it has obviously a big bank group that's a little unwieldy because just the sheer numbers of the group but making a lot of progress and as both Craig and I said in our prepared remarks, we're pretty confident that we're going to find a solution that's going to be a favorable outcome for us.

[Operator:]

The next question comes from the line of Brian Hogan with William Blair.

[Brian Hogan:]

Can you talk about your other non-accrual, PK and the kind of status there?

[Richard Buckanavage:]

Brian, no change from prior quarter and I'd probably say no change from the quarter before that. Frustrating for us that we haven't made much progress on that one. It is a fairly large group, [indiscernible] eight or nine lenders in that group. And I think what's further complicating matters is we have several non-traditional, more hedge fund-like debt providers in this group which are complicating some of the negotiations between the debt providers in the company. We hope to make more progress long before this point in time, but I can tell you, very little progress has been made from the prior quarter. We're still working at and certainly active in the conversations, but unlike the estimate on Fox as it relates to resolution, I think I don't have a real good answer for you there. Fortunately, it's a relatively small investment for us and certainly the fair value is down to fairly de minimis level at this point.

[Brian Hogan:]

The credit quality movements, grades one, two, three, four, five, there's been some movement within those tiers, can you discuss those movements? I mean, the grade one had a nice increase, grade two went down. I'm sure it was partially due to the movements to one and then the grade three also increased and then where does Fox Factory lie on that tier?

[Richard Buckanavage:]

That movement in three is -- the Fox Rent A Car, that movement in the three bucket was largely driven by Fox Rent A Car, moving to a three-rated credit. So, that's a big component of it.

[Brian Hogan:]

And then the ones to go from two to one?

[Richard Buckanavage:]

Two to one, we rarely get asked about those, Brian, we had a few go from two to one just based on -- obviously, they're performing one means they're performing substantially above expectation or the budget. Usually, our rule of thumb is about 10% above the underlying budget. So that kind of gives you a sense for pretty substantial performance above where we thought it would be which warrants the upgrade to one from two.

[Brian Hogan:]

I don't recall seeing it, but were there offsets to the unrealized depreciation?

[Richard Buckanavage:]

There was, definitely. Some of our syndicated credits other than one which was a big contributor to our -- as I mentioned three of the write-downs in the quarter were -- the majority of our unrealized depreciation, obviously one was Fox. The other was a syndicated deal which is having some struggles there. Rest of the syndicated portfolio actually did see an uptick as you probably saw across the industry as a whole. Prices did firm and they continue to firm quite frankly even post 6

[Craig Kitchin:]

This is Craig. It was mixed across the portfolio. We had in total -- of all the credits that appreciated, we had $1.1 million in appreciation and then of the investments that depreciated, it was $2.2 million in total.

[Brian Hogan:]

I know you amended your credit facility. One of the, I guess, things you can do now or plan to do as of very recent is this HCAP equity. Can you discuss your plans for that entity?

[Craig Kitchin:]

It was really a tax-driven issue. It's the blocker corp, so equity investments that we hold and other pass through entities, LLCs or partnerships will drop down into the blocker corp and be able to trap that taxable income there. We don't have a lot of that yet, but we've got more than we did a year ago and a lot of BDCs have but it's designed to prevent us from potentially passing the good income test and also to trap the tax dollars down there.

[Brian Hogan:]

And then last one for me is the SBIC timing. I thought you mentioned you were looking into that. Can you provide any updates there?

[Richard Buckanavage:]

Our policy is really to hold off and commenting on the FDIC process until we're complete and through it and at that time to announce either a successful process or not. Certainly, we feel like it fits what we're trying to do. I will say that what we've heard is that there's been given where BDCs were trading a couple of months ago that there was certainly a little bit of a tapping the breaks at the SBA relative to BDCs. If you are a new applicant, obviously some of the existing SBIC holders have received subsequent licenses, but on the new front, things -- our sense was things that slowed down a little bit there. So, we have not -- I don't have a recent update for you and one that we would be comfortable providing given one, the long term nature of that process and certainly the uncertainty.

[Operator:]

[Operator Instructions]. Your next question comes from the line of Mitchel Pennsylvania with Janney Montgomery Scott.

[Mitchel Penn:]

When you guys go into the non-sponsored market, can you talk a little bit about how much yield you pick up and then contrast that with sort of the credit losses and I mean, expected credit losses, so, of course, you get higher yields, but with that comes higher risks and so I'm just curious what experience you've found over the years with that non-sponsored market relative to the sponsored market?

[Richard Buckanavage:]

We don't see any real discernible trend, if you will, between sponsored and non-sponsored losses. Maybe at any given point in time if you took a snapshot, you might see one being higher than the other. But having done this for -- coming up 30 years, it's not -- there really isn't a trend and I think the reason that we see is, one is, as I said earlier, it has to be an industry that we have some deep knowledge and it can't be a brand new industry that we've not invested in or a specialized industry where it really does put us at in jeopardy where the reliance on maybe one or two key people. In fact, we don't have a relationship with someone that again we compare should into a situation. I would say on average, we're picking up maybe as much as 150 basis points to 200 basis points in the non-sponsored space versus the sponsored space; again, plus or minus, obviously not every transaction, but I would say on average. Keep in mind that the structures are much tighter in the non-sponsored transactions, tighter covenants, more covenants, lower leverage across the board. I would say that for us anyway, how we approach the non-sponsored market is that if it's two identical transactions for all intents and purposes and one had a sponsor and one didn't, we're going to provide leverage at a deferred and lower leverage point in the non-sponsored deal than in the sponsor deal, recognizing that we need more cushion potentially in the non-sponsored deal. And quite frankly, how we react and how we manage that particular investment is influenced by whether there's a sponsor or not. Obviously, when things don't go as planned, we do have a sponsor in those deals where there is one to help identify the reasons, come up with a plan of action. We play some of that role in the non-sponsored transactions. So, we're a little bit more active and a little bit more active earlier in the process than we would otherwise be. So, there's a lot of factors that go into the non-sponsored asset class that makes it an asset class that although it may have some unique risks versus the other that we can operate in from a long term perspective and not incur more significant losses than we otherwise would with a sponsor.

[Mitchel Penn:]

One thing, I'm curious, are the costs of doing a non-sponsored deal, are they higher for the shareholder or are they higher for the advisor? Does the advisor absorb that?

[Richard Buckanavage:]

As it relates to cost of acquisition, if you will, of customer acquisition, I would say the costs are definitely little bit higher for non-sponsored deals. And yes, it is the advisor that absorbs those costs. The cost of flying to a particular location, going in and doing due diligence and we always have our diligence. On non-sponsored deals, we always have a deposit that has given to us to cover due diligence expenses. So, it's very unlikely we'll have that issue, but we do have some extra costs associated with that -- with non-sponsored deals which again are covered by the advisors, so not the BDC.

[Operator:]

Currently we have no further questions. I'll turn the conference call back over to Mr. Buckanavage for closing remarks.

[Richard Buckanavage:]

Thank you, everyone. We appreciate the interest in our Q2 earnings and we look forward to catching up with you in November to discuss Q3.

[Operator:]

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