Harvest Capital Credit Corporation
Q1 2015 Earnings Call Transcript

Published: 10 May 2015

[Operator:]

Good morning, my name is Felicia and I will be your conference operator today. At this time, I would like to welcome everyone to the Harvest Capital Credit First Quarter 2015 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session, [Operator Instructions] Thank you. I would now like to turn the conference over to Rich Buckanavage, the Company’s CEO. Please go ahead, sir.

[Richard Buckanavage:]

Thank you operator. Good morning everyone and thank you for joining us for this conference call to discuss our financial results for the first quarter ended March 31, 2015. I am joined today by our Chief Financial Officer, Craig Kitchin. Before we get started this morning, 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. I would like to cover a few high level topics this morning that I believe are particular interest to our shareholders including our deployment activities for the first quarter, portfolio takeaways at quarter-end, our current pipeline of potential investment opportunities and the current state of the debt market. Then I will turn the call over to Craig, who will discuss our financial results in more depth and the end, we’ll provide time to field any questions our call participants may have. I am mostly pleased with our financial results for the first quarter of 2015. Harvest Capital Credit generated core net investment income of approximately $1.9 million, or $0.30 per share. $0.02 of the delta between last quarter’s core net investment income of $0.36 per share and the first quarter’s $0.30 per share is attributable to a higher interest cost associated with our baby bond offering closed in January. Another factor that impacted earnings was the timing of our deployment activities, which were higher than expected at $13.9 million was more weighted toward the end of the quarter resulting in a more modest impact on the first quarter earnings. These new investments however will contribute meaningfully to Q2 earnings. The remaining shortfall is attributable to the lack of any meaningful exits during the quarter and to a lesser extent the continued asset shift to uni-tranche loans, which typically carry a lower yield than second-lien loans and Mezzanine investments. As you may recall from last quarter’s call, we did carry over $0.17 per share or 2014 earnings into 2015 and we used $0.04 per share in the first quarter to support our Q1 dividend. With $0.13 per share of remaining spillover earnings, shareholders should be confident in our ability to support future 2015 distributions. Net asset value per share declined to $14.30 per share from $14.60 per share at prior quarter end. It is worth noting that approximately 65% of this quarter’s unrealized depreciation is attributable to our two existing non-accrual loans. Subsequent to quarter end, I am pleased to report that we have reached a preliminary agreement to restructure our Solex debt investment, one of our non-accrual loans which we hope will minimize the potential for future value deterioration and provide shareholders with a realistic opportunity to recover previously written down amounts. We hope to be in a position to discuss the restructure in more depth during our second quarter earnings call. Now, let me address first quarter’s deployment activity. During the first quarter, we closed four transactions totaling approximately $13.9 million in investment commitments. Two of these investments were made to entirely new companies with the remaining two transactions representing follow-on financings for existing portfolio companies. The weighted average yield on these investments is 12.82%. Also during the quarter, we exit two small placeholder investments totaling approximately $1 million in the aggregate and earned between 4% and 5% IRRs for the brief period that we held these investments. With two new investments, and the sale of two placeholder investments, the number of portfolio companies remains static at quarter end at 29. As of March 31, despite a stable portfolio of 29 companies, the dollar growth of the portfolio enable us to continue to reduce our reliance in any single investment with our top five obligors declining to 33.4% from 34.4% last quarter and our top ten declining to 55.7% from 58.4%. We continue to remain diligent regarding industry diversification as well and at the end of the first quarter it is worth noting that of the 28 end-markets that we have invested in, every industry sector represents less than 10% of our total portfolio. Our diversified investment strategy that includes an array of different asset classes continues to deliver benefits to shareholders in terms of risk mitigation. At March 31, our portfolio was comprised of 52% senior secured debt investments, 44% junior secured debt investments and 4% of equity and equity-like securities. As a result, 96% of our total portfolio and 100% of our debt investment is secured by at least a first or second lien providing tangible benefits to our shareholders. Because senior secured debt investments typically have a floating rate pricing structure, for the fifth consecutive quarter, we were able to increase the percentage of floating rate investments relative to our total portfolio to 63.1% as compared to 59.7% last quarter and 45.9% at the end of the prior year comparable period. As such, our future earnings have no exposure to raising interest rates. In fact, our earnings would benefit materially in such a rising rate environment. From a credit perspective the portfolio continues to perform acceptably with a weighted average risk rating at March 31 of 1.87, an improvement from 1.97 last quarter. Consistent with prior periods, the portfolio weighted average risk rating has remained at or below the two risk ratings assigned to each investment at the time that investment is made. At March 31, we had eight investments rated 1, 15 rated 2, two 3 rated investments, one 4 rated investment and one 5 rated investment. We currently have two loans on non-accrual status. As I mentioned earlier in my comments we have reached a preliminary agreement to restructure our solid debt position. We have nothing new to report on our other non-accrual loan CRS. Unfortunately, the negotiations between the interested parties is taking much longer than we anticipated. The good news is that we and the other debt holders continue to maintain an active and collaborative dialogue with the other stakeholders of the business and we are hopeful that a satisfactory resolution can be reached in the near future. Lastly, the weighted average annualized yield of the debt portfolio at March 31 was 14.8% compared to 15.1% at the end of the prior quarter. The decline in portfolio yield is attributable to the continued focus on senior secured debt or the uni-tranche investments that tend to have lower yields. Quarter-to-date, we have not closed any new financings. However, we have witnessed an uptick in deal activity. Although new investment activity is up meaningfully from the first quarter, competitive pressures continue and our success rate remains well below historical levels. Currently, we have two mandated transactions to link $5.5 million, both of which are uni-tranche investments with an average yield of approximately 11.8%. I should note that there can be no assurances that these transactions close during the current quarter or that they close at all. However, both financings are targeted for a Q2 close. As we look ahead to the remainder of the quarter and year, we expect the debt markets to remain very competitive. While certain segments of the market might be reversing course to a more lender-friendly environment, we have not witnessed such a correction in the lower middle-market. Our hope is that, as other parts of the market begin to provide a higher level of acceptable risk-adjusted investment opportunities, some of the larger players who have entered our market in the past few quarters return to their historical target markets. The recent announcement by GE Capital to exit the middle-market leverage loan space might just be this catalyst for this upward migration out of the lower middle-market by some of the more recent entrants to our target market. That concludes my formal remarks this morning. So I’ll now turn the call over to Craig Kitchin.

[Craig Kitchin:]

Well, thanks, Rich and good morning, everyone. Core net investment income for the quarter was $1.9 million or $0.30 per share, compared to $2.1 million or $0.34 per share in the first quarter of 2014. The decrease in core earnings is in part a function of continued spread tightening in the portfolio as the weighted average effective yield was 14.8% at March 31 compared to 15.7% a year ago, It’s also partly due as Rich mentioned to the higher interest expense from our Q1 bond offering which reduced earnings by $0.02 in the quarter and lastly, in Q1 of 2014, $0.05 of incentive fees were waived by our external manager increasing earnings in the quarter a year ago. As compared to Q4 of 2014 when Core NII was $0.36, the decrease is a function of the higher interest expense and the fact that we had much lower fee income this quarter with no material realizations. In Q4, we had $0.06 of income related to the acceleration of deferred fees and prepayment fees on two exits and the syndication fee on one new origination. The timing of realizations can create lumpiness in earnings the same pay-offs that accelerate fees into income in the current period also detract from earnings in future periods as there are fewer fees left to amortize. So it makes for a tough comparison in the quarters that don’t have realizations and we are feeling the effect of that this quarter. However, also as Rich mentioned, the pay-offs in 2014 did create or help to contribute to undistributed earnings that need to be paid out in 2015. We had $0.17 of spillover taxable income and essentially paid our $0.04 of that in Q1. I would also point out that earnings for the quarter were still lowly levered. We had $40.6 million in debt at the end of the quarter putting our debt-to-equity ratio at 45%. The average debt balance outstanding during the first quarter was $29.4 million for a debt-to-equity ratio of 33% both of which are well below our target leverage level of 75%. Net income was $0.05 per share for the quarter compared to $0.36 per share in Q1 of last year. The decrease is primarily a result of $0.27 of depreciation in the portfolio this quarter compared to $0.03 of appreciation a year ago. The depreciation was concentrated in a couple of names with $0.18 of it coming from our two non-accrual accounts. The two non-accrual investments, CRS and Solex represent 4.5% of the portfolio at fair value this versus 5.8% last quarter. They represent 6.5% of the portfolio at cost versus 7.1% last quarter. And the NII impact of these accounts being on non-accrual for the quarter was $0.05. As of March 31, the fair value of the portfolio was $125.4 million versus amortized cost of $126.4 million reflecting $1 million of net unrealized depreciation in the portfolio. I should mention that we have a look back feature on the incentive management fee agreement such that, no more than 20% of the cumulative trailing three year net income can be paid out in incentive fees to the manager over that period of time. This prevents the manager from collecting incentive fees on net investment income if there are large below the line losses. However, due to not paying any incentive fees for the first year after the IPO, incentive fees on NII were not turned off or reduced this quarter as a result of the net depreciation. As at quarter end, we had $2.4 million in cash and $13.1 million drawn on our $55 million credit facility. So with our cash and borrowing capacity, we should have enough dry powder to fund new investment activity in 2015. But with the $55 million facility and the $27.5 million of bonds, our total debt availability is $82.5 million which essentially maxes out our borrowing capacity until additional equity is raised. I would point also though that we have about $20 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 11.5% at quarter end. As of quarter end, our NAV was $14.30, down $0.30 from a quarter ago, as net income of $0.05 per share was offset by $0.34 in dividends paid during the quarter. With that, I will turn the call back over to Rich.

[Richard Buckanavage:]

Thanks, Craig. We appreciate everyone’s participation in our call this morning. I would now ask the operator to open up the lines for any questions our participants may have.

[Operator:]

[Operator Instructions] And your first question comes from the line of Troy Ward with KBW.

[Troy Ward:]

Thank you. Craig, can you go back - towards the end of your commentary there, you were talking about the available liquidity based on the borrowing base. I missed that. Can you reiterate what you were talking about there?

[Craig Kitchin:]

Yes, we’ve got a $55 million credit facility and as of March 31, $13 million was drawn, so the difference is our ability to borrow up today. And my point was with the bonds and once we’ve maxed up the credit facility we’ll have about $82.5 million of debt which is above our target leverage level and getting us close to one to one on debt-to-equity.

[Troy Ward:]

Okay, but you do have the additional $42 million available on the facility, you have access to that based on your borrowing base today, correct?

[Craig Kitchin:]

Borrowing base today gives us access to virtually all of it, but as we put on new investments that creates more room. So, yes, we will be able to draw on all of it.

[Troy Ward:]

So your current capacity, you have more than enough capacity to go to your 0.75 leverage?

[Craig Kitchin:]

Correct.

[Troy Ward:]

Okay, and now thinking about that leverage target, now that you have the unsecured baby bonds out there, does – Rich, does that give you more confidence because of the structure of those two run at fully at your targeted leverage?

[Richard Buckanavage:]

Yes, I guess, we felt pretty good about the target leverage level of 0.75 to 0.8 and I think we feel even better given that we have completed the baby bond and that feel is a prudent level of leverage given the type of portfolio that we have.

[Troy Ward:]

Okay, and then quarter-to-date you said, you have nothing closed as of yet. A couple mandated for $5.5 million, if I heard correctly. Have you had any repayments? And then also can you speak to your expected level of repayments in the portfolio? Like this quarter, do you expect tat to continue, those impact fee income?

[Richard Buckanavage:]

No repayments thus far in the quarter. As we look ahead, as you know it’s always difficult to predict repayments. I would say that quarter-to-quarter, very difficult, and that’s we are aware of something that we were to be notified is going to be repaid. But over the course of a year, I would certainly say that we would expect to have through the remainder of the year, I would say that we expect to have other repayments just by virtue of the maturity of the portfolio.

[Troy Ward:]

Okay, and then one final one. You talked about the shift to uni-tranche and how that’s having an impact on the yield, you know, year-over-year I think it was down 100 plus basis points. Can you speak to the reason why you focus more on uni-tranche today with the lower yield versus maybe a more traditional straight-sub or yields were a little bit higher?

[Craig Kitchin:]

Yes, I would say that, early on, there was – I think some of that shift was self-imposed. It was really a strategic decision that we made to put more floating rate assets on to the balance sheet obviously to better match our borrowing costs. Now that that’s largely complete. What we are really – even though it seems like we are continuing with that strategy, we are really not as focused on solely uni-tranche financings. We are actually very interested in and continuing to look at second-lien term loans, flat out term loans and mezzanine investments for the obvious reason you just mentioned, higher yields. But we don’t really dictate in many cases, what that will look like. In some cases, we are given the option to present votes a uni-tranche financing and a strictly junior capital solution. In some cases, the borrower or the sponsor will indicate their preference for a particular strategy and of course, we want to lead with the strategy that the borrower is asking for. So, in this particular case, it’s not as much a function of strategy, it’s more a function of just taking what the market gives us.

[Troy Ward:]

And one final one, Rich, how confident are you that the market, the availability of assets in the market over the next three, six, nine months will allow you to grow the portfolio to a level where you can give – can run at that kind of fully leveraged capacity? I mean, first quarter was pretty anemic across the board. It seems like in the BDC space, now mostly BDC’s peers are up-market from where you are and you are in the lower middle market, but it seems like the activity in your market is pretty slow as well. So, just how do you feel the ability to grow the portfolio over the course of 2015?

[Richard Buckanavage:]

Yes, well, first quarter was slow, if I look at the total volume of opportunities that we’ve reviewed. I mean, fortunately for us we were able to find a few quality transactions and capable of winning those and closing them, because 13.9 for us is a pretty good quarter. In fact, as I mentioned in my prepared remarks, the second quarter right now at least, is if we look back at the average first quarter versus the average thus far, in the second quarter, we are materially higher in opportunity, average opportunities that we’re reviewing. The concern we have is really just the lack of change in the competitive landscape and it remains extremely competitive in our marketplace and as I alluded to, the problem we are facing is bigger players coming down market with a lower cost of capital and pricing in transactions lower than we are willing to compete. So, it’s challenging to look out as you may know and I would say that we are getting at that and we are seeing an uptick in opportunities and our view is that we are going to find enough opportunities to continue to grow the portfolio over the course of 2015. It doesn’t take a lot for us. As I mentioned, a quarter where we do $15 million is a good quarter for us. And if you throw couple of those together, we get pretty close to that 0.75 leverage level. So, maybe the changing landscape as I mentioned, the GE situation might just be that factor that drive some of the larger players that come into our market recently maybe to go back to their own = the target markets that they really wanted to approach when they started their firms and leave the lower middle-market for the folks like us who play there consistently. But that’s our hope anyway.

[Troy Ward:]

Great. Thanks, Rich and Craig.

[Operator:]

Thank you. [Operator Instructions] And your next question comes from the line of Brian Hogan with William Blair.

[Brian Hogan:]

Good morning. Actually, Troy asked most of my questions, but I do a couple follow-ups. There with the GE, how much do you see GE in the market today? Or is it more you see – they expect the benefit from some of the guys that have come down into your market going back up because of GE or is it because you also see GE in your market too?

[Richard Buckanavage:]

No, we really don’t come across GE in our market. The benefits to the lower middle market would be those that I already outlined which is maybe, enabling some of the bigger players to find enough opportunities to satisfy their appetite and have them migrate back out of the lower middle-market into the traditional middle-market where GE is obviously a very formidable player or was a formidable player.

[Brian Hogan:]

All right, and then, the other income line on the P&L. That was light definitely compared to the last quarter and obviously you had some one-time items in the fourth quarter. But what should be a - I guess, an ordinary run rate number for that? Was it, very light there?

[Craig Kitchin:]

In the fourth quarter, that other income line captured the structuring fee on one syndicated deal or one originated deal that we syndicated and a prepayment fee on one of the pay-offs. So there, it’s more of a one-time line item in Q4 and hard to predict going forward.

[Brian Hogan:]

Right. Do you see any other syndication opportunities or…?

[Richard Buckanavage:]

We do, I think when we talked about that transaction last quarter we had outlined it is something that we wanted to continue to do where we would step-up for a larger position than ultimately we’d like to hold underwrite that position and then sell down a little bit to get to a target hold level. We are working on something right now that has very similar characteristics as that transaction. And so, it is something, but it is also – keep in mind, it’s a small part of our business. We don’t have - quite frankly we don’t have the balance sheet or liquidity to do too much of that but where situations exist where we can win a transaction by stepping up to the entire tranche and then syndicate, we certainly want to take advantage of those opportunities.

[Brian Hogan:]

And then, I guess, little bit on the credit quality and the movements there, I mean, I understand the two – but just can you just go into little more detail doing the buckets as just to get the grade ones moved up healthy amount and just kind of explain some of the movement there?

[Richard Buckanavage:]

Yes, we had a couple of twos move up to one this quarter. So that’s certainly driving that number. We didn’t really have any change to our watch list credits. The three fours and fives, so that really – there was no migration upward in the watch list, it really was kind of status quo as far as risk rating goes and the main benefit from 1.97, 1.87 is really virtual. I think it was three 2s went from a 2 to a 1. So that was the main driver of the improving risk rating.

[Brian Hogan:]

And then, broadly speaking the economy, looking at your portfolio, how do you feel at it today?

[Richard Buckanavage:]

We have pretty good insight into our portfolio. As you know, we do have board observation rights in many of our companies and we got to hear not only comments that are more rearview mirror-oriented, but also, discussion of future activity and right now, we are not hearing about any storm clouds on the horizon. Right now, the portfolio, absent really our two non-accrual loans, the portfolio was actually performing quite well if you take those out and you look at the movements that I just alluded to in the portfolio and we have quite a few one rated credits in our portfolio. And that’s a testament I think to the overall economic environment. So, right now, we feel pretty good.

[Brian Hogan:]

Okay, thank you.

[Operator:]

Thank you and your next question comes from the line of Mitchell Penn with Janney.

[Mitchell Penn:]

Hi guys. Can you just give us some color on Novatex acquisition?

[Richard Buckanavage:]

Yes, that’s Mitchell, you obviously noted that, the other more meaningful piece of our unrealized depreciation was Novatex and if you take that depreciation and combine it with our two non-accrual loans, you’ve basically accounted for, I think some – almost 85% of the entire depreciation. We - I would say have some limits on what we can say, but, that is a – for us a 3 rated asset, I am sorry, a tier-3 asset, so, level 3 asset. So it is something that we value ourselves because of the lack of liquidity at least in the marketplace. Although the marks were taken into account that are available, even though there is not a lot of trading activity. That mark that we took was prior to a – call that, the company had with its lenders. Earlier this week, obviously we can only - we have to cut-off the values at some point to get the Q filed on time. But that company had a little softness in some of its numbers and obviously drives a lower valuation. But, based on the information that we heard the other day, we feel good about the credit. And right now, our position is that we are going to continue in that credit.

[Mitchell Penn:]

Okay, thanks.

[Operator:]

And there are no further questions at this time.

[Richard Buckanavage:]

Okay, well thank you everyone. We appreciate your interest this morning and we look forward to talking again for our second quarter earnings.

[Operator:]

Thank you. And this concludes today's conference call. You may now disconnect.