Harvest Capital Credit Corp. (NASDAQ:HCAP) Q2 2018 Results Earnings Conference Call August 9, 2018 11:00 AM ET
Joseph Jolson - Chairman & CEO
William Alvarez - CFO, Chief Compliance Officer & Secretary
Richard Buckanavage - MD, Head of Business Development
Brian Hogan - William Blair
Mr. William Alvarez, Chief Financial Officer, you may begin your conference.
Great. Thank you, operator. Good morning, everyone, and thank you for participating in this conference call to discuss our Financial Results for the Second Quarter ended June 30, 2018. I am joined today by our Chairman and Chief Executive Officer, Joseph Jolson, and by Richard Buckanavage, our Managing Director, Head of Business Development.
Before we start, I would like to remind everyone that 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. Now I'll turn the call over to Joe.
Thanks, Bill. Our second quarter results continued to reflect our reduced capital deployment as well as stable but below our historical performance on credit quality. We are increasingly optimistic about both these issues could improve over the next few quarters.
We currently have three mandated deals, totaling $17.1 million that could close in the next few months, but we do expect an increase in payoffs. We have also implemented specific resolution plans on each of our 3, 4 and 5-rated credits and hope to show improved credit metrics in the next 6 months.
Including the $2.5 million investment we just closed, we would need to add roughly $17 million in new investments net of payoff to hit our historical target leverage ratio of 0.75 to 0.8 to 1, excluding any need to increase quarter-end borrowings temporarily to meet certain RIC diversification tests.
While our current level of mandated deals would mostly achieve this goal, we do anticipate an increase in payoffs in the next few quarters could result a successful investments continue to mature and are sold to attract cheaper financing sources in the current competitive environment.
While this could create a bit of a challenge to redeploy our capital in a timely manner, we will benefit from higher prepayment fees and the acceleration of deferred origination fees in our net investment income, if and when this happens.
At June 2018, our weighted average risk rating was flat at 2.24, which we hope to improve on in the coming quarters through a combination of growth and the successful execution of each of our company-specific plans.
Our only 5-rated credit, Infinite Care, remains on non-accrual status, that has paid us our cash interest each quarter, which we have chosen to defer into reducing the net carrying value of the investment, costing us $0.02 per share per quarter of net investment income.
Infinite Care's operations have stabilized this year since Harvest is getting more actively involved as its sole owner, and recent results have been encouraging. Our only 4-rated credit is currently in a sales process, which we hope could close by the end of the year.
Now I'll turn it over to Rich for some more color on the investing environment. Rich?
Thanks, Joe. Our second quarter's deployment was modest and totaled $5 million, which was comprised of $4.7 million in debt commitments and approximately $300,000 in equity investments. We have an activity involved in one new portfolio company and follow-on investments into existing companies, we had hoped for greater number of new investments to close in Q2, given our robust pipeline, but delays in several transaction limited this quarter's deployment.
During Q2, we had 1 full exit totaling approximately $1.4 million. This exit, when combined with scheduled amortization and some modest prepayments, resulted in net portfolio growth of approximately $2.5 million during the quarter. Despite this level of net portfolio growth, we continue to maintain adequate diversity with 29 portfolio companies, invested across 15 separate industry sectors.
Post quarter end, we closed another financing with a new portfolio company, totaling $2.5 million. Harvest led the junior secured term loan portion of the debt financing to support a buyout of a lower middle market company by Northeast-based private equity firm. This investment is a floating rate debt tranche that is priced at 3-month LIBOR plus 10.5%.
Current state of the markets in the segment in which we primarily compete remains competitive. However, we have witnessed a moderate uptick in new investment opportunities that began back in Q1.
Our current pipeline is solid with over 20 average new investment opportunities during Q2. Currently, we have three mandated transactions totaling approximately $17.1 million, which are expected to close within the next few months, all of which are holdovers from Q2. All three mandates are unitranche financing investments.
As stated in prior quarters, we are making a concerted effort to best position Harvest for a rising interest rate environment. These 3 mandates, in conjunction with the closed transactions earlier this week, all being floating rate investments, helps with this initiative.
Looking ahead, we are optimistic about our deployment prospects over the next quarter or two, given the mandated transactions, pipeline levels and the quality of the opportunities in our pipeline.
We are aware of a few potential repayments in the portfolio in the remainder of the year, and our objective is to deploy sufficient capital to offset these possible repayments. Credit spreads have stabilized in our market, so we anticipate being able to deploy future capital at acceptable yields.
As we move into 2019, and assuming we are able to utilize additional leverage capacity pursuant to the Small Business Credit Availability Act, which will subject us to reduce statutory asset coverage ratio of 150% starting in May of 2019, our competitiveness should only increase, and we would expect our deployment activity to accelerate over the course of the year.
With that, I'll turn it over to Bill, who will discuss our financial results in more depth.
Okay. Thank you, Rich. Investment income for the quarter was $1.6 million or $0.25 per share compared to $2.5 million or $0.39 per share in the second quarter of 2017. For 2018 year to date, net investment income was $2.8 million or $0.44 per share versus $4.8 million or $0.75 per share in the 2017 comparable period.
Net income for the quarter was $0.8 million or $0.13 per share compared to a loss of $1.9 million or $0.29 per share in the second quarter of 2017. For the 6 months ended June 30, 2018, net income was $2.9 million or $0.45 per share compared to net income of $0.5 million or $0.07 per share for the 6 months ended June 30, 2017.
I'd like to highlight a few notable items for the second quarter. Net investment income decreased during the quarter due to a couple of factors. Investment income decreased $1 million as a result of a smaller investment portfolio, which decreased approximately $16.6 million from June 30, 2017.
Net operating expenses decreased $0.2 million, principally as a result of lower interest, directly as a result of lower average bank debt outstanding in the second quarter of 2018 as compared to 2017.
Professional fees were lower offset by an increase of incentive fees earned in the quarter. Net income increased $2.7 million in the quarter ended June 30, 2018 compared to the quarter ended June 30, 2017.
During the second quarter, the company recorded net realized and unrealized losses on investments of $0.8 million, which included $0.5 million of a deferred tax provision for unrealized gains in our equity blocker as compared to the quarter ended June 30, 2017, where the company recorded net realized and unrealized losses on investments of $4.4 million.
We recognized fee income of $0.5 million in the 3 months ended June 30, 2018 as compared to $0.2 million in the first quarter of '18. Our fees are deferred until they are either earned, amortized into income over the life of the investment or fully recognized when investment payoff occurs. As a result, our fees will fluctuate quarter-to-quarter depending on portfolio activity.
As of June 30, 2018, the fair value of our portfolio was $120.6 million with a cost of $122.8 million, reflecting a $2.2 million of net unrealized depreciation in the portfolio at the end of the quarter.
As of June 30, 2018, we had a debt balance of $51.8 million, consisting of $23 million of bank debt and $28.8 million in unsecured notes, where debt to equity ratio of approximately 65%, up from approximately 56% at December 31, 2017.
At quarter-end, we had $11.8 million of cash and approximately $11.3 million of undrawn capacity on our $55 million credit facility. Our cash and borrowing capacity provides us with sufficient liquidity in order for us to execute our business plans for 2018.
In addition, at June 30, we had 3 syndicated loans, totaling $8.3 million, which we could monetize into cash to be invested in our core lower middle market strategy as attractive opportunities arise. Subsequent to quarter-end, we received a full repayment on one of our syndicated loans, totaling $1.8 million.
As of quarter-end, our net asset value was $12.52 per share, down $0.14 per share from year-end, principally as a result of paying $0.59 in dividends for the 6 months ended June 30, 2018, versus $0.45 of an increase in assets from operations in the same period.
For the quarter ended June 30, 2018, our net investment income was $0.25 per share, slightly below our dividend of $0.285 per share. At June 30, 2018, we had $1 million of undistributed net investment income on a GAAP basis, which represents above $0.15 per share.
During the quarter ended June 30, 2018, we repurchased 14,678 shares of our common stock at an average price of $10.32 per share at a total cost of $0.2 million.
Subsequent to quarter-end, as I previously mentioned, we received a full repayment on one of our syndicated loans, Sitel Worldwide Corporation, for $1.8 million. In addition, we also received full repayment of our senior secured loan in AMS Flight Leasing, $0.1 million, and our senior secured term loan in IAG Engine Center, $0.4 million, generating an IRR of 15% and 15.7%, respectively.
Also, the company received its final distribution on its revenue linked security investment in IAG Engine Center, $0.5 million, generating an IRR of 48.9%. The company also entered into agreement with Flight Lease 20 [ph] regarding a potential future payout of proceeds from the sale of an asset due to the extent sales proceeds exceed $0.6 million where the company would receive 50% of any excess over $0.6 million with a $0.3 million cap.
Excluding any potential future payouts, our exit of the IAG Engine Center investment should add about $0.03 of net investment income in Q3.
Now I'll turn the call back over to Joe.
Thanks, Bill. I am pleased with the progress we've made in the past few months towards reinvesting our excess capital, implementing an independent portfolio of management function and integrating our administrative services operation in our New York office.
Short term, we expect these initiatives will improve our results. Longer term, we believe the new structure will allow us to scale investments more efficiently as we seek to take advantage of the new BDC leverage test to the benefit of our investors through improved returns on equity with lower structural credit risk as a higher weighting of senior secured loans in the portfolio.
Operator, we will now be happy to take any questions at this time.
Sure, thank you. [Operator Instructions] Your first question comes from the line of Brian Hogan of William Blair. Your line is open.
Hi. How is it going, Brian?
Going well. Thanks. Question on your last commentary commencing offices in New York and leveraging that -- the basic. I guess, what is the normal -- normalized run rate for G&A expense line? I mean, it was elevated in the first quarter and we were just shy of 500 in the second quarter? Is second quarter more reflective of an ongoing rate or is that too low?
Yes. I'll let Bill take that.
Sure. Brian, the second quarter is probably more representative of what the rest of the year is going to transpire into. First quarter, it was a little lumpy with some things that were happening, but second quarter is more representative.
Right. That's helpful. I guess, I was a little confused on the IAG and the revenue-linked distribution of what's all going on in there. Can you just kind of like flesh that out a little bit more -- in more detail of why that's - and what's the ongoing...
Yes, I mean, it's different from BDC to BDC, but we've always chosen the most conservative accounting treatment when we originate investments in deferring 100% of any 1 piece or other forms of compensation into the future. So if an investment pays off, particularly if it pays off before maturity, often we have some level of deferred income that we recognize.
So in this particular case, we had estimated cash flows when we booked this revenue-linked security. That we -- that were attractive but we thought we're still conservative and as it's turned out, the net cash flows ended up being higher than that. And that's why there was income recognition in the third quarter. I don't know if you want to elaborate on that, Bill?
Yes, just a little bit. I mean, there was several components to the investment we had. We had a couple of debt pieces and then we had this revenue-linked security piece that basically was resulting from cash flow off of various parts and things of that nature that were a part of the original arrangement.
So when we got an opportunity to exit the transaction at a gain, get our debt paid off and then get basically a final distribution on some of those part sale, there is a -- there is some residual items and residual assets that are left over that if they achieve a certain milestone selling those additional residual assets, then we'll participate in the upside.
But at this point in time, there is no certainty whether we'll realize anything or not. So basically, we'll exit transaction, recognize the gain and have a 0 value for any future potential payoff.
And have you guys opened fee income line or where does that actually show up?
Well, that will be -- there'll be a couple lines where you're going to have fee income line. There's going to be an interest line. There's going to be down in the -- gain a line. So it's kind of a complex transaction that it's a long landscape in the financials.
All right. I guess, getting into the mandate that -- spillover, why are they taking, because I know, it's kind of lumpy and it takes -- things take longer than always anticipated.
And then what payoffs do you expect in the back half for near term? I know there is -- was about $17 million or so in the -- scheduled for the fourth quarter and first quarter of '19, but what kind of payoffs do you expect?
Rich, maybe you should take that one.
Yes, Brian, the variety of reasons why transactions get delayed. And there is really no commenting from the transactions that experience delays. So it's, in one case, companies doing better than originally -- the original financial statements indicated and a purchase price adjustments being negotiated, which is actually quite common both up and down.
So, again, variety of reasons that resulted in delays, none of which are problematic, all of which are just kind of more common garden variety reasons for things to get delayed. So they -- and while we expected some maybe not all of those to close in Q2, we definitely had anticipated 1 to 2 of those closing in Q2.
We now expect them to close in Q3. So we're pretty confident, and the mandate's actually getting to a closing but again, not by June 30, obviously.
And the payoffs?
Payoffs, we know there are some discussions going on, on the portfolio about refinancing some parts of our debt. As Joe mentioned, there is 1 company that is commencing a sale process, so we have no idea of what the success of that might be, both on the refinance and on the sale process. So we are aware of some things going on.
We haven't necessarily quantified that but obviously, in a mature portfolio, these kind of events are pretty typical that they happen from time to time. So we do know they're ongoing, and we're cognizant of the fact that we need to offset that and, obviously, more. Our goal is to not just offset runoff, but to deploy more capital to actually generate net portfolio growth.
Yes. And I do not know what is your pipeline? I mean, I understand you have $17 million of mandates, but what does your actually pipeline look like? Is it healthy? Can -- do you think you can grow? Obviously, you said, credit spreads have stabilized as well which makes normal attractive environment for you guys?
Our portfolio has average about 20 opportunities and about $140 million in deployable capital. So pretty good pipeline for us in numbers, number of deals, dollar amounts.
As you've probably heard me on the prior quarters, quality of pipeline is also very important to us. It doesn't make -- it doesn't benefit us to have 25 companies that are not investments we'd like to pursue. So we're pretty encouraged.
And I would say, we're not sure what's driving the substantial uptick in deal flow, but as I said, by about mid first quarter maybe in the February time frame, we saw a very dramatic uptick in deal flow and it really hasn't subsided since.
And our competitiveness in the marketplace seems to have increased as well as demonstrated by the couple of closings and the three mandates. We had a business active for quite some time.
And I think 1 - I guess, more of a bigger picture perspective, vision for Harvest here. It's been a tough slot growing the portfolio. And what -- have your book values kind of eroded a little bit? And how do you get the operating earnings up, as you're just putting more capital to work and getting those investments?
How do you -- what does it look like in 2 years? I mean, to get your leverage up to 1.5 times given the leverage ratio, I mean, just -- how long does it take to get there?
Well, I think that we're still trying to get clarity as to -- with the marketplace of credit line lenders type of thing in terms of that. But assuming that, that goes through as we think it will in the next quarter or two, we are going to increase leverage.
And we do plan on increasing it with a higher weighting in unitranche and senior secured. So that should have the impact, I think, if you play it out, if we get to 1.3, not 2 to 1 but maybe 1.3 to 1, you could model it out, Brian.
And I think that you get to a few hundred basis points higher return on equity. Assuming current environment competitiveness continues, it could be a lot better than that if the credit spreads widen out for us back to historical norms.
But we pick up a couple hundred basis points for shareholders, increase the percent of the portfolio that's in variable rate, right now, it's about 50%, that would take it up into the 70% to 80% level.
And obviously, the structural credit risk where we're in a first lien position right now. About half of our investments are first lien, so that would also bring out weighting up to a similar amounts of lower credit risk more upside if interest rates continue to go up and a higher returns for shareholders with just some modest increase in leverage is kind of what we're looking at.
And from a timing point of view, the current environment just stays where it is now. We can't increase leverage until early May based on the rules. But I would say, it would probably take about a year from that to get to that 1.3 kind of leverage rate, if that helps you.
Yes, that does. And I guess, what are we -- are you targeting -- what do you think is achievable?
Well, I think that higher is better, but we have to weigh the risk of the investment of where we are in the cycle. So the yields are lower when you're looking at unitranche and senior secured versus second lien type of things.
So as we move a little bit more in that direction, that will have a mitigating effect on what the ROE could be. But we're not really giving guidance or projections.
But I think that this quarter, incentive fees, partial incentives fees were earned first time in a while. And I think as we continue to put capital out, you'll see incentive fees go up, I think, as well as earnings.
And so we're targeting -- if -- when we get to the ratio, we're targeting not the increased leverage. We're feeling pretty good that we can cover the current dividend in that level based on current market conditions, and then you can back into what ROE that is.
Sure. Thank you for your time.
[Operator Instructions] There are no further questions at this time. Presenters, you may continue.
Yes. We appreciate everyone's interest in the company, and we look forward to reporting our results in the second week in November. Thank you very much.
This concludes today's conference call. Thank you for your participation. You may now disconnect.