Harvest Capital Credit Corporation
Q3 2016 Earnings Call Transcript

Published: 9 Nov 2016

[Operator:]

Good morning, my name is Jessica and I will be your conference operator today. At this time I would like to welcome everyone to the Harvest Capital Credit earnings call. [Operator Instructions]. Richard Buckanavage, you may begin your conference.

[Richard Buckanavage:]

Thank you, operator and good morning, everyone. Thank you for joining us this morning for our conference call to discuss the financial results for the quarter ended September 30, 2016. I'm joined today by our Chief Financial Officer, Craig Kitchin. Before we start our call, Craig, could you please provide the safe harbor disclosure?

[Craig Kitchin:]

Yes. 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:]

Thank you, Craig. I would like to address a few high-level topics before turning the call back over to Craig who will discuss our financial results in greater detail. Overall, I am pleased with the performance of the business, with $0.47 per share of core and net investment income in Q3, Harvest Capital has now generated $1.21 per share of core NII through the nine months ended September 30. This level of core NII is $0.19 per share above dividends paid for that nine-month period of approximately $1.02 per share. This performance, when combined with our expected results for Q4 should put the Company in a position to cover the annual dividend level for the second consecutive year. Should this level of profitability persist through the remainder of 2016, we will once again generate spillover income in 2016 that can be used to support 2017 distributions, providing shareholders with confidence in our ability to at least maintain the current dividend payment level for the foreseeable future. Q3 2016 was another slow quarter for us in terms of capital deployment. We closed two follow-on term loan investments in existing portfolio companies, WBL1 and WBL2. That totaled $3.5 million in the aggregate. The cash yield on these two follow-on investments is 13% and 14.5%, respectively. Also during the quarter, we expanded our investment activities in our aerospace vertical by closing a $2.1 million senior secured term loan in IAG Engine Center. This investment carries a cash interest rate of 14%. In conjunction with our debt investment, Harvest capital has granted a revenue-holding security entitling us to a share in the proceeds from sale of inventory. Offsetting our $5.6 million of capital deployment activities, we did experience two pre-payments during the quarter. First, a full exit of our $100,000 equity investment in Optimal Blue, in which we earned an IRR of 85.5%. And two, a full repayment of our $4 million junior secured debt investment in Language Line, in which we earned a 12.2% IRR. With these two exits, we have experienced now 22 portfolio realizations since inception that have produced a weighted average IRR and MOIC of 23% and 1.35%, respectively. These last two exits continue to build on an outstanding track record of generating equity-like returns by investing in debt securities and should provide further evidence to shareholders of our targeted and disciplined investment strategy. Subsequent to quarter end, we completed a modest follow-on equity investment totaling $25,000 in an equity raise completed by one of our existing portfolio companies, Bright Media. This was a company in which we already had an equity investment. Also subsequent to quarter end we closed an amendment and restatement of our existing credit agreement with Fox Rent-A-Car. The amendment coincided with the company's full refinancing of its corporate line of credit with new financing provided by various fleet lenders. The main features of the agreement that were amended include Harvest Capital moving up the capital structure by obtaining a first-priority security lien for its debt investment from a junior secured lien position previously. The shortening of the maturity of our investment to September, 2017 from October, 2019 and the commencement of scheduled amortization beginning March 31, 2017. To reward Harvest for its thoughtful approach to the company's covenant default situation over the previous few quarters, as part of the amendment, we received an amendment fee of $750,000. All of our previously past due interest from Q2 and Q3 was paid in full and the blockage prohibiting the ongoing receipt of current interest was eliminated. As such, the Fox debt investment was returned to accrual status this quarter. I am pleased with the performance of the portfolio overall. From a risk perspective, the portfolio continues to exhibit solid results with a weighted-average risk rating of 1.97 at 9/30, a slight improvement from 2.01 at prior quarter end. As of 9/30 we had one loan on non-accrual status with a cost basis of approximately $2.1 million or 1.5% of the total portfolio. And one loan on PIK non-accrual status with a cost basis of approximately $6.6 million or 4.6% of the total portfolio. This performance was one of the contributors to our achievement of a net asset value per share of $13.75 per share at 9/30 compared to $13.71 per share at prior quarter end. We continued to aggressively manage diversification in the portfolio across a variety of metrics, by [indiscernible] industry sector, asset class, as well as a mix between fixed and floating investments. We continue to maintain prudent abagore diversification across the across the portfolio. Our top five abagore concentration increased only modestly to 35% versus 32.8% at prior quarter end. Our industry diversification remains sound as well. Our largest concentration represents 13.6% of the total portfolio and we continue to have no direct exposure to the oil and gas sector which has served us well over the past several quarters. We do, however, have an immaterial, less than 1% exposure to oil and gas on our loan investment in CLO equity. That CLO is in its wind-down phase, so we would expect this small exposure to continue to decline very rapidly in the near future. At September 30, our portfolio was comprised of approximately 50% senior secured debt, 45% junior secured and 5% in equity and equity-like securities. As a result, approximately 95% of our total portfolio and 100% of our debt investments are secured by a first -- at least a first or second lien with no unsecured debt investments. The majority of our deployed capital is invested in floating-rate investments which at approximately 66% helps to insulate Harvest Capital's future earnings from the possible negative impact of rising interest rates. In fact, we'll enjoy upside in net interest margins as interest rates do rise. For example, we estimate that NII would increase by approximately $445,000 with an increase in LIBOR of 100 basis points, all else being equal. This equates to approximately $0.07 per share of higher annual earnings. The current state of the markets in the segment in which we primarily compete continues to be very competitive. While structural elements of completed financing such as leverage and financial covenant packages, for example, have been stable, pricing continues to be the primary basis of competition. Unique transaction-specific factors to each investment, such as size of the company, industry and competitive factors and working capital and CapEx intensity, appear to play a very small role in the way that investments are priced. It is at moments like this historically when some financial firms have fallen into the trap of either chasing yield or growing for growth's sake which evidenced by our deployment trajectory year to date and our current portfolio heel trends, we have declined to participate in. The silver lining this quarter compared to the market environment as I described on the last earnings call, is that the amount of overall opportunities has increased materially. This is an encouraging development. However, I want to reiterate the competitiveness of the current market. Our discipline to only to pursue transactions that are accretive to our dividend and enable us to at least maintain and hopefully improve, the portfolio's solid diversification and risk metrics will most likely limit the level of capital deployment we can anticipate in the short term. That concludes my formal remarks. Now I'd like to turn the call over to Craig to discuss our financial results.

[Craig Kitchin:]

Thanks, Rich and good morning, everyone. Net investment income and core net investment income for the quarter were $3 million or $0.47 per share compared to $2.2 million or $0.35 per share in the third quarter of 2015. Year-to-date net investment income is $7.6 million or $1.21 per share, compared to $6.3 million or $1 per share last year and core net investment income for the year to date is $1.21 per share compared to $0.98 per share last year. A couple of things to note about earnings for the quarter. Number one, as Rich mentioned, Fox Rent-A-Car was restructured and returned to accrual status during the third quarter. As a result, we booked $808,000 or $0.13 per share, of interest income in Q3 related to Fox. After incentive fees, the interest income from this deal was $0.10 per share with approximately $0.05 of this related to Q2 when it was on non-accrual and the other $0.05 relating to Q3. Number two, CRS was placed on non-accrual as of the beginning of the third quarter. As a result, we did not book approximately $238,000 or $0.04 share in PIK and OID income during the quarter that we otherwise would have. We did, however, book a little over $0.01 per share in cash income that was collected during the third quarter. And number three, the three-year total return look-back feature in our management agreement was triggered again in Q3, resulting in about $410,000 or $0.065 per share haircut to the incentive fee expense. As a reminder, the look-back feature requires that no more than 20% of the last three years pre-incentive fee net income can be paid to the manager over that same period of time. So portfolio depreciation has an impact on the NII incentive fee. Net income for the quarter was $2.4 million or $0.38 per share compared to net income of $800,000 or $0.14 per share in the third quarter last year. The increase was driven by higher NII and about $700,000 less in total realized and unrealized portfolio depreciation. PIK income represented 7.9% of our total interest income in Q3, compared to 5.4% of interest income in Q3 last year. For the most part over the last couple of years, the percentage of our income that has been PIK has been on the decline. It did go up, however, this quarter due to our investment in Yucatan which has a large PIK component. Yucatan was a growth financing which is why it was structured the way it was, heavy on the PIK early on and is a bit of an outlier for the portfolio. Overall we still have a very small percentage of our total income as PIK. As of September 30, the fair value of the portfolio was $137.5 million versus amortized cost of $142.9 million, reflecting $5.4 million of net depreciation in the portfolio at the end of the quarter. As of September 30, we had a total debt balance of $54.5 million for a debt-to-equity ratio of 63%, down from 73% last quarter. The reduction is a result of investment payoffs and pay-downs during the quarter and resulting pay-downs on our line of credit. As of quarter-end we had $3.2 million in cash and about $28 million of undrawn capacity on our line of credit. So with our cash and borrowing capacity, we have enough dry powder to execute the business plan in the short term. Additionally, as I've noted on other calls, I would point out that we have $23 million of lower-yielding syndicated loans on the balance sheet that could be monetized and invested in core deals with higher yields. The syndicated loans had an effective yield of 11.5% at quarter-end. As of quarter-end, our NAV was $13.75 per share, up $0.04 from last quarter, as we had net income of $0.38 which exceeded the $0.34 in dividends paid. One other thing I will mention is that we carried over approximately $0.22 per share in undistributed 2015 taxable earnings into this year that were deemed to be paid out in the third quarter of this year as part of our regular distributions. So because $0.22 of this year's dividends were a payout of last year's excess earnings and because we've also out-earned the dividend this year by about $0.20 year to date, we will likely be spilling over a bigger number this year than we did last year. This should give investors an added degree of comfort as to the sustainability of current dividend levels. And lastly, I would also mention that we did continue modestly with our share buy-back program in the third quarter. We bought back 20,000 shares for about $250,000. 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. And with that, I'll turn the call back to Rich.

[Richard Buckanavage:]

Thanks, Craig. Operator, we know that some of our participants will have some questions for us this morning. So if you could please open up the lines for any of our participants that do have questions.

[Operator:]

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

[Brian Hogan:]

Quick question on asset mix going forward. Equities, obviously just 5% of your portfolio at the moment and it seems to be taking a little bit more interest in equities at the moment, maybe on the margin. But how big of the portfolio you think equity would be over time? Or is 5% where you want it to be? Thoughts there?

[Richard Buckanavage:]

I think the equity asset class is interesting to us in a couple of different instances. First, in those situations where we have the opportunity to make a modest co-investment alongside, in some cases, a private equity group, in a debt transaction that we also find appealing from an equity perspective. We've done some of that pretty consistently over time. The numbers might be getting a little bit larger, but, again, pretty small, I would say, co-investments of a couple hundred thousand dollars. We've done that and will continue to do that. Other areas where we've made some equity investments more recently have been in the aerospace category. This vertical is relatively new for us. We've got four investments there and we've taken some equity positions there. Again, pretty modest relative to the debt investment. But those are asset plays that we find particularly attractive, given the long-lived, relatively stable value of aircraft engines and certain other aerospace parts that we've been able to identify. And then the third category in which we haven't done much of to date that we may do more in the future, obviously really more case by case as they become available. Those would be where we might partner with a sponsor and become a little bit more active alongside that sponsor and make investments of a larger magnitude. All that being said, we think that 10% in the foreseeable future. We don't see the equity going over 10% of the portfolio.

[Brian Hogan:]

Obviously add a nice kicker when they actually work out.

[Richard Buckanavage:]

And you saw the Optimal Blue situation this past quarter which was a perfect example. Obviously with an 85% IRR, the only problem is we wish we'd invested more.

[Brian Hogan:]

Right. Hopefully you have more of those in your portfolio. So is it -- if I back out the Fox Rent-A-Car catch-up from the second quarter and maybe normalize for the incentive stuff, is it fair that the run rate core earnings were like $0.37, is that reasonably --?

[Craig Kitchin:]

Brian, this is Craig. In my remarks I tried to talk about the three potentially non-recurring components of income for the quarter. So we did have $0.05 related to Fox that was really attributable to Q2. We were charging default rate interest during the second quarter and the third quarter, so we won't have that going forward. But as Rich mentioned, there was that amendment fee of $750,000 that will bleed into income over the remaining year life of that credit. So going forward, the Fox contribution should be over $0.05. CRS was a $0.04 impact during the quarter and it's hard to predict if that will continue or not. And then the other one that's hard to predict is the haircut to the incentive fee. We do have that total return look-back feature that captures the last three years of capital gain activity, both realized and unrealized. So it's impacted it the last two quarters and it's possible it'll impact it again. Just depends on what the portfolio does, depreciation- or appreciation-wise.

[Brian Hogan:]

Sure. And that $750,000 Fox amendment fee, is that going to be amortized over the next, essentially 12 months or is that --?

[Craig Kitchin:]

That's correct, yes.

[Brian Hogan:]

Okay. The unrealized losses you realized on the portfolio this quarter, how much of that was mark to market for yield and how much of that was performance?

[Richard Buckanavage:]

Say, Brian, about, I would say 80% to 85% credit and really concentrated in three particular credits which not surprising, the one PIK non-accrual CRS Infinite Care and PK, those really represent the majority of that decline. The rest of the portfolio actually had some nice appreciation.

[Brian Hogan:]

And then, if I read correctly the Northeast Metal Works, that defaulted during the quarter? Is that -- did I read that correctly?

[Richard Buckanavage:]

That's right. They had a modest financial covenant violation and we're working with the company. Not inconsistent with what you saw more macro-oriented from an economic perspective. It is a company that's an industrial company that does feel the ebbs and flows of the general economic environment. They did see a slowdown, as much of the economy did in the second quarter. Good news is that, consistent with what we're now seeing in the third quarter and into the fourth quarter, the industrial sector does seem to have picked up from where we were mid year and they're starting to see that as well. Very comfortable with where we're there. We don't, quite frankly, shy away from covenant defaults. We set covenants tight for our borrowers for a very specific reason which is to catch problems early. This is one that we think will resolve itself over time by virtue of their underlying demand pick-up.

[Brian Hogan:]

And then quickly on capital use, you bought back shares in the quarter, appreciate that, especially discounted. What is your thoughts going forward, what is it in your prepared remarks, just a little bit more color on that would be appreciated, given the increase in the opportunity pipeline, but the competition. A little bit more commentary, please.

[Richard Buckanavage:]

Yes. I think it just goes back, Brian, to the way we look at the world. We don't grow for the growth's sake, we don't chase yield. In fact, if anything, we're take a more cautious approach right now and I think with a slight preference for uni-tranche and senior secured-type assets. If we're unable to find appropriate investments with an appropriate risk-adjusted return, we always have that relative value angle to say, well, why don't we just buy back our portfolio? It's the portfolio that we know, it's the portfolio that's performing well with an over 14% all-in yield to it. So it really will be predicated upon where the stock trades, obviously and then what we're seeing in the pipeline. We're encouraged by the uptick because it's a pretty material uptick from where we were in Q2. We didn't see that coming. If you recall my remarks in the last earnings call, we were fairly pessimistic with regards to the pipeline. But we're in the midst of a pretty nice pick-up and hopefully we'll find some new opportunities to put dollars to work.

[Operator:]

And your next question comes from the line of Ryan Lynch from KBW.

[Ryan Lynch:]

First one has to do with Fox. Could you provide a little background for why that loan was placed on non-accrual one quarter and then removed basically that next quarter? Was it more of a technical default that just needed some little bit of a restructuring or a mending to the credit facilities? Or was there a downturn in the business and then it snapped back?

[Richard Buckanavage:]

If you recall when we described that situation last quarter, we described the default as being a default, but not one that we were overly concerned about. We felt like the senior lender who was the agent for a senior lending group of nine banks, we think that they acted a little too harshly and a little too quickly. And of course, that led to us being blocked, so we did receive a blockage notice which led us to put the credit on non-accrual. And as you gleaned from my prepared remarks, the company was able to take what we think is actually a pretty solid year financially and was able to refinance that entire senior bank group with replacement financing. And as I alluded to, we improved our position in the capital structure, shortened our maturity to put it on a short leash, just to make sure, given the macro trends, that this was going to continue. And then, of course, I think we were rewarded by the company for taking a more thoughtful approach than their senior lenders to this situation and we were able to negotiate with them what we think is an attractive amendment fee of $750,000. So, we always felt good about the underlying performance of that business. Obviously that wasn't shared by the senior lender, but this business, I think, proved it out that it is a credit that can obtain replacement financing and we're excited to see that happen so quickly. When you have a management team and ownership that is working collaboratively with its various stakeholders, you can achieve a positive outcome. That's what happened here. Even though it seems rather rapid, it's something that took a lot of hard work on the part of the company.

[Ryan Lynch:]

I want to move over to the competition front for a minute. From what we've been seeing and looking at data, seems like there's been a lot of capital formation in middle-market direct lending. A lot of players are coming in there, probably to chase yield as yields have been falling around the world. Are you seeing any new competition coming into the lower middle market? Are you guys seeing any competitors, as more players move in the middle market, are you seeing any players that are traditional middle market lenders now start to dip down to lower-middle market in seek of yield?

[Richard Buckanavage:]

Yes, certainly the latter. We do see from time to time larger firms that haven't historically looked at the lower-middle market who will dip their toe from time to time. I think that's largely driven by search for yield, as you alluded to and in some cases search for deal flow. I'm not sure that's the case right now because there seems to be quite a bit of deal flow. But maybe they're enticed by the relatively higher yields in the lower-middle market. With regards to new groups, I am always shocked. There's probably not a two-week period that goes by that we don't get an e-mail from some obscure group out of somewhere that has no background in credit that now has a pool of capital that they're investing in lower-middle markets. As you alluded to, there continues to be quite a bit capital formation occurring in the search for yield in a very low yield environment globally. We're hopeful as rates begin to rise that there's other places for that capital to be invested and not in our market. Rest assured, we're going to stay disciplined. As you've seen here in the last two quarters, we're finding a little bit here and there. We're finding opportunities in the portfolio to put some additional capital to work. We're looking at some unique niches, the aerospace vertical is a perfect example of that, to find ways to put dollars to work with attractive risk-adjusted returns, but we've never held ourselves out as going to be the fastest grower or the biggest BDC. Hopefully we're one that is one of the more profitable.

[Operator:]

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

[Richard Buckanavage:]

Thank you, everyone. We appreciate you joining us this morning and we look forward to sharing information about our fourth quarter and full-year results early next year. Thank you.

[Operator:]

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