Horizon Technology Finance Corporation (NASDAQ:HRZN) Q3 2023 Earnings Call Transcript

Horizon Technology Finance Corporation (NASDAQ:HRZN) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Greetings, and welcome to Horizon Technology Finance Corporation Third Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Megan Bacon, Director, Investor Relations and Marketing. Thank you, Ms. Bacon. You may begin.

Megan Bacon: Thank you, and welcome to Horizon Technology Finance Corporation’s third quarter 2023 conference call. Representing the company today are Rob Pomeroy, Chairman and Chief Executive Officer; Jerry Michaud, President; and Dan Trolio, Chief Financial Officer. I would like to point out that the Q3 earnings press release and Form 10-Q are available on the company’s website at horizontechfinance.com. Before we begin our formal remarks, I remind everyone that during this conference call, the company will make certain forward-looking statements, including statements with regard to the future performance of the company. Words such as believes, expects, anticipates, intends or similar expressions are used to identify forward-looking statements.

These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ on a material basis from those projected in these forward-looking statements. And some of these factors are detailed in the risk factor discussion in the company’s filings with the Securities and Exchange Commission, including the company’s Form 10-K for the year ended December 31, 2022. The company undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. At this time, I would like to turn the call over to Rob Pomeroy.

Rob Pomeroy: Welcome, everyone, and thank you for your interest in Horizon. As we always do on our quarterly calls, I will update you on our performance and our current overall operating environment. Jerry will then discuss our business development efforts, our portfolio events and our markets, and Dan will detail our operating performance and financial condition. We will then take some questions. We had a strong quarter from the standpoint of net investment income with NII significantly exceeding our quarterly distributions. However, our net asset value as of the end of the quarter was negatively impacted by adverse events in our portfolio, which resulted in markdowns in the fair values. Our Advisor Horizon Technology Finance Management and its experienced and expert team remain focused on our portfolios credit quality as we navigate through the stressed macro environment and maximize the value of our portfolio over the longer-term.

Turning to our specific results for the quarter, we generated net investment income of $0.53 per share well in excess of our declared distribution level, due largely to higher interest rates on our floating rate debt investment portfolio, as well as lower incentive fees earned by our Advisor. Dan will further discuss the impact of incentive fees on NII in his remarks. Based on our outlook and our undistributed spillover income of $1.23 per share as of September 30, our Board declared regular monthly distributions of $0.11 per share through March of 2024, as well as an additional special distribution of $0.05 per share for the fourth consecutive year payable in December. We achieved a portfolio yield of over 17% on our debt investments for the quarter once again at or near the top of the BDC industry.

We raised $14 million of equity from our at-the-market program at a premium to NAV, further enhancing our investment capacity. Our portfolio at quarter end stood at $729 million growing modestly from June 30. We finished the quarter with a committed and approved backlog of $202 million, providing us with a solid base of opportunities to thoughtfully grow our portfolio. As a reminder, most of our funding commitments are subject to our portfolio companies meeting certain key milestones. Finally, we ended the quarter with a net asset value of $10.41 per share. The largest impact on our NAV was a result of our fair value markdown of our debt investment in Evelo Biosciences, which Jerry will provide more detail about. We continue to work closely with and support not only Evelo but all of our portfolio companies as we focus on improving our overall credit profile and maximizing recovery.

We continue to seek high quality new investments to grow our portfolio despite the challenging macro environment. As we close out 2023, we are hopeful that the volatility in the macro environment will ease and the negative credit cycle will improve. Our team remains focused on credit quality and executing on our investment strategy in order to create additional value for our shareholders over the long-term. With that, I will now turn the call over to Jerry and Dan to give you more details and color on our performance. Jerry?

Jerry Michaud: Thanks, Rob, and good morning, everyone. Our portfolio grew slightly from the prior quarter to $729 million as of September 30 as a result of our careful approach to new originations in the face of ongoing, macroeconomic, and VC headwinds. Our portfolio size was impacted partially due to our portfolio markdowns. In the third quarter, we funded eight debt investments totaling $88 million, including debt investments to four new portfolio companies and four existing portfolio companies. While we maintain a healthy pipeline, we expect to remain selective in originating debt investments during the remainder of 2023. Our onboarding yield of 13.9% during the quarter remained near our historic highs, continuing to reflect the higher interest rate environment in our markets as well as our pipe – our discipline in structuring and pricing transactions, which we expect to produce strong net investment income.

During the quarter, we experienced one loan prepayment, two refinance loans and one partial paydown totaling $38 million in prepaid principal. We expect prepayments to remain muted in the fourth quarter of 2023 compared to our historic levels given the weak IPO in M&A markets. Our debt portfolio yield of 17.1% continues to validate structuring our investments with floating interest rates in a rising interest rate environment, we again generated one of the highest debt portfolio yields in the BDC industry. As of September 30, we held warrant and equity positions in 99 portfolio companies with a fair value of $42 million. As a reminder, structuring investments with warrants and equity rights is a key component of our venture debt strategy and a potential generator of shareholder value.

In the third quarter, we closed $178 million in new loan commitments and approvals and ended the quarter with a committed and approved backlog of $202 million, compared to $159 million at the end of the second quarter. We believe our committed backlog with most of our funding commitments subject to our portfolio companies, achieving certain key milestones provides a solid base as we seek to prudently grow our portfolio. We also continue to work closely with all of our current portfolio companies to navigate the choppy macro environment. Unfortunately, our portfolio company Evelo Biosciences had two unfavorable trial outcomes during 2023, including a failed Phase 2a trial for a psoriasis drug 2923 in October. As a result, in the third quarter, we recorded a significant unrealized loss on our Evelo debt investment.

We creatively restructured our debt investment in the prior quarter and continued to diligently work toward achieving additional recoveries on our investment. Subsequent to the end of Q3, Horizon received an additional cash paydown of $11 million from Evelo with the $5 million paydown Horizon received from Evelo early in the third quarter, Horizon has received a total of $16 million in principal repayments on its Evelo debt investments in 2023. In addition, we are working closely and collaboratively with the company as it seeks strategic alternatives to maximize the value of its core technology platform. Overall, we are closely monitoring all of our portfolio companies and are working with their management teams, investors and other stakeholders to assist them in the challenging macro and venture capital environment.

As of September 30, 87% of our debt portfolio consisted of 3 and 4 rated debt investments, compared to 90% as of June 30. Our five 2 rated debt investments at September 30 are slightly higher than the four 2 rated debt investments in Q2. We also have two 1 rated debt investments at the end of Q3, which represent 2.3% of our total debt portfolio. Turning now to the venture capital environment. According to PitchBook, approximately $37 billion was invested in VC backed companies in the third quarter of 2023, compared to $46 billion in Q3 of 2022 and $87 billion in the third quarter of 2021. VC activity levels remain under considerable stress as VC investments in new portfolio companies made in 2021 and the first half of 2022 are significantly overvalued in the current economic market.

As a result, the ability of VC backed companies to raise new capital is challenging. Combined with a virtually closed IPO market and a muted M&A market, VC backed technology and life science companies are finding it increasingly difficult to raise much needed capital to fund operations and growth. On a positive note, judging from our healthy pipeline, we believe there is significant number of opportunities to invest in quality companies seeking capital, particularly debt capital to fill their ongoing needs. We believe venture lenders, especially public BDCs, remain best positioned to fill this need, but the opportunity is tempered by the existing overall market conditions. In terms of VC fundraising, only $9 billion was raised in the third quarter, and the market is now on pace to record a nine-year low while the avenue to public exits is still largely closed, VCs committed capital from their LPs remains elevated due to the amounts raised during the good times and the reluctance to invest in the current market.

While we expect this to continue in the near-term, the amount of sideline capital does provide VCs with the ability to support their well-performing portfolio companies until improved exit markets emerge. VC-backed exit activity improved in the third quarter as total exit value for the quarter was $36 billion, driven primarily by the Instacart and Klaviyo IPOs. However, their stock prices have underperformed post IPO and their IPOs have not provided the momentum that the market sought for new IPO issuances. The M&A market for venture backed companies also remained at historic lows during Q3. There is a potential positive indicator for M&A in the life science market with big pharma companies sitting on historical high levels of cash and with blockbuster drugs coming off patent protection in the next four years.

Big pharma needs to – need for new drugs and potential blockbusters could lead to significant M&A activity with big pharma companies buying smaller development companies with drugs in the clinical pipeline, in order to restock their own drug pipelines. In terms of market conditions for new venture loan investment, we expect the challenging environment to continue into at least the early portion of 2024. Accordingly, Horizon will maintain a pragmatic and cautious approach to new investment opportunities, while focusing on preserving the value and quality of its current portfolio. When the global economic and investment environment stabilizes and the venture capital ecosystem improves, we believe Horizon’s solid reputation and long-term market presence will allow us to reaccelerate its portfolio growth through the new – with new high quality venture debt loans.

A key baseline for future prudent portfolio growth is our committed, approved and awarded backlog, which as of today stands at $227 million and our advisors pipeline of new opportunities, which as of today stands at over $1 billion. To sum up, we continue to sharply focus on credit quality and providing our portfolio companies with support and alternative solutions when necessary to ensure optimal outcomes for our portfolio. Where are attractive high quality companies looking for venture debt solutions, we will look to thoughtfully add to our pipeline and backlog, with an eye toward prudently growing our portfolio. Based on current portfolio size and yield, we believe we remain well positioned to generate solid NII for our shareholders and additional long-term shareholder value.

With that, I will now turn the call over to Dan.

Dan Trolio: Thanks, Jerry, and good morning, everyone. During the third quarter, the yield generated from our debt investments once again produced NII that more than covered our distribution. In addition, we continued to strengthen our balance sheet through our ATM program successfully and accretively raising an additional $14 million of capital, providing us with capacity to prudently make new investments. As of September 30, we had $80 million in available liquidity consisting of $47 million in cash and $33 million in funds available to withdrawn under our existing credit facilities. Currently have $25 million outstanding under our $150 million KeyBank credit facility and $181 million outstanding on our $250 million New York Life credit facility, leaving us with ample capacity to grow the portfolio.

Our debt to equity ratio stood at 1.27:1 as of September 30 and netting out cash on our balance sheet, our leverage was 1.12:1, which was below our target leverage of 1.2:1. Based on our cash position and our borrowing capacity on our credit facilities, our potential new investment capacity at September 30 was $241 million. For the third quarter, we earned total investment income of $29 million, an increase of 25% compared to the prior year period. Interest income on investments increased primarily as a result of the higher average size of our debt investment portfolio for the quarter and increases in the variable interest rates on our debt investments. Our debt investment portfolio on a net cost basis stood at $717 million as of September 30, a 2% increase from June 30, 2023.

For the third quarter of 2023, we achieved onboarding yields of 13.9% compared to 13.6% achieved in the second quarter. Our loan portfolio yield was 17.1% for the third quarter compared to 15.9% for last year’s third quarter. Total expenses for the quarter were $11.6 million compared to $12 million in the third quarter of 2022. Our interest expense increased to $7.1 million from $5.3 million in last year’s third quarter due to an increase in average borrowings and higher interest rates on our borrowings. Our base management fee was $3.2 million, up from $2.8 million in last year’s third quarter, due to an increase in the average size of our portfolio. We had no performance based incentive fee in the third quarter compared to an incentive fee of $2.8 million for last year’s third quarter.

This was due to the deferral of incentives otherwise earned by our advisor in the quarter under our incentive fee cap and deferral mechanism. The deferral was driven by unrealized and realized losses on our portfolio. Net investment income for the third quarter of 2023 was $0.53 per share compared to [indiscernible] per share in the second quarter of 2023 and $0.43 share for the third quarter of 2022. The company’s undistributed spillover income as of September 30 was $1.23 per share. We anticipate that the size of our portfolio, the increase in our portfolio’s interest rates along with our predictive pricing strategy will enable us to continue generating NII that covers our distributions. As we have said previously, while we expect to experience repayments through the end of the year, we still believe repayments will be below our historical levels given the current environment.

To summarize, our portfolio activities for the third quarter, new originations totaled $88 million, which were offset by $9 million in scheduled principal payments and $38 million in principal prepayments, refinancings and partial paydowns. We ended the quarter with a total investment portfolio of $729 million. Given the macro environment, we expect to remain selective in the near-term with respect to originations. At September 30, the portfolio consisted of debt investments in 56 companies with an aggregate fair value of $680 million and a portfolio of warrant, equity and other investments in 102 companies with an aggregate fair value of $49 million. Based upon our portfolio outlook, our board declared monthly distributions of $0.11 per share for January, February and March 2024, and a special distribution of $0.05 per share payable in December of 2023.

We remain committed to providing our shareholders with distributions that are covered by our net investment income over time. Our NAV as of September 30 was $10.41 per share, compared to $11.07 as of June 30, 2023, and $11.66 as of September 30, 2022. The $0.66 reduction in NAV on a quarterly basis was primarily due to our paid distributions, realized losses, and adjustments to fair value, partially offset by net investment income. As we’ve consistently noted, 99% of the outstanding principal amount of our debt investments, bear interest rate at floating rates with coupons that are structured to increase as interest rates rise with interest rate floors. As of today, 95% of our debt portfolio will benefit from additional increases in the prime rate.

This concludes our opening remarks. We’ll be happy to take questions you may have at this time.

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Q&A Session

Operator: Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] The first question comes from the line of Bryce Rowe with B. Riley Securities. Please go ahead.

Bryce Rowe: Thanks. Good morning.

Rob Pomeroy: Good morning.

Bryce Rowe: Let’s see, wanted to start on just the level of spillover, obviously, it’s growing. You’ve paid a special dividend here for several consecutive years. Any way to kind of think about kind of sizing that spillover up and how you’re thinking about managing it given the increase in spillover?

Dan Trolio: Yes. Good morning, Bryce. We look at the distribution every quarter with our board members and taking consideration, the activity in the portfolio and the income that it’s generating and obviously the spillover. At these levels, we’ll continue to do that and look at it through the regulatory requirements of distributing that, but nothing’s certain today.

Bryce Rowe: Okay, Dan. That’s helpful. Thanks. I guess, you’ve got time to kind of figure that out, but I was just curious if there was an update there. Next question, just wanted to ask about a couple of portfolio companies that I guess you’ve seen a change in some of the maturity date won the NextCar, you’ve got a maturity date of actually, it was yesterday, and that was moved up. Any update you can provide there kind of given the size of that investment. And then also wanted to ask about Nexii Building. Any update on that particular investment? Thanks.

Jerry Michaud: Yes. So this is Jerry. So as it relates to NextCar, that company does continue to raise capital in the marketplace, and they would be in an interesting position if there were better exit markets. And that was their expectation, along with a lot of other company – VC-backed companies where the exit markets just aren’t there for them. So they continue to raise capital, continue to get inside support from investors, and they’re in a very dynamic market. They’re in the car kind of subscription rental business, and it is a growing platform, but until the exit markets kind of open up, they’re going to continue to be internally funded, and we’re going to continue to work with them to help know get to a better exit opportunity. And that’s kind of where we are.

Bryce Rowe: And then, Jerry, if you could just touch on Nexii Building as well.

Jerry Michaud: Yes, Nexii kind of similar situation, very interesting product, good demand for their product, difficult market in the kind of construction area. Right now, they do have overseas contracts that they are plugged into. And so, again, I think in better exit markets, there would be opportunities for this company to do something a lot more exciting. But right now, they’re just continuing to be internally funded. They actually did get an outside investment, I think, in the third quarter from institutional investors. So we continue to work closely with them and again, hopefully to get to a better market where they can be more opportunistic and how they’re thinking about financing their business.

Bryce Rowe: Excellent. Thank you for the commentary. I’ll hop back in queue for some others to take a chance. Thanks.

Operator: Thank you. Next question comes from the line of Christopher Nolan with Ladenburg Thalmann. Please go ahead.

Christopher Nolan: Hi for Evelo, were there any incremental investments made in the fourth quarter?

Dan Trolio: No.

Christopher Nolan: Okay. And on the call, you said there was $16 million in repayments in the third quarter.

Dan Trolio: Yes. So in the third quarter, the company completed a pipe transaction. They raised $25 million, mostly from inside investors, led by Flagship, who has about $140 million or had about – I think it’s more than that now invested in the company. And when that transaction closed, we received a $5 million pay down, and we converted $5 million of our debt to equity, which at the time gave us about an 11% ownership position in the public company. And the expectation or the hope was certainly that the clinical trial for Psoriasis would have turned out better. We were very disappointed. Obviously the company was very disappointed in the results of that. But once they announced the results of that trial that didn’t meet its endpoints, the company paid down an additional $11 million, which we actually just received last week. So we got $16 million in pay down since the third quarter and combined with what we received here in the – early in the fourth quarter.