Description

People are familiar with BDCs, in general, and with WhiteHorse Financial (WHF), in particular, from ele2996’s great write up last spring. Hence, there is no need to provide much background on this idea.

In short, WHF is a small-cap BDC that has gotten smacked-around with recent market volatility. The notable decline in the shares last week (closing at $12.57 on Friday vs. $13.73 on Thursday) is largely technical driven (as a small cap name in an infamously retail-oriented market segment) and not reflective of the fundamentals.

Recent volatility provides an attractive entry to an objectively attractive dividend (currently ~10.5%). However, perhaps more importantly, the collapse of global yields (with the 10 Year Treasury crossing the 1.0% threshold) further improves the WHF story from a relative value standpoint. I would argue a world starved for income-based investments will bid compelling double-digit yields out of existence. WHF is an excellent investment to capitalize on that structural overlay. 

To level set, WHF reported its 4Q19 results (period ended 12/31/19) on Monday, which the market viewed favorably; the stock retraced much of the pre-crisis selloff.  WHF posted NII of $0.39, which topped Street expectations of $0.36 and out-earned its regular dividend of $0.355. Much of this (admittedly one-time) gain resulted from the accrual of $1.2mn of interesting income on the StackPath term loan. The investment had previously been on non-accrual, but WHF successfully exited at par during the period.

WHF additionally posted NAV of $15.32/share, down roughly 1% in the quarter due to a special dividend of $0.195/share. With the stock in the $13.80 context, shares trade at roughly 89% of NAV.

WHF reported two investments on non-accrual, AG Kings Holdings and Grupo Hima, which were both on non-accrual last quarter as well. Management maintained their ~$0.80 mark on Grupo Hima (which operates hospitals in Puerto Rico) and provided relatively upbeat commentary on the call. WHF lowered its mark on grocery store AG Kings to $0.58 from $0.65 last quarter, and were less constructive in their outlook.

Even with these bad loans (thus far at least), non-accruals represent just 1.3% of fair value as of 12/31. More importantly, WHF has done an excellent job of limiting these troubled investments, with non-accruals averaging just 0.7% of the portfolio (at cost) over the last three years.

Outside of earnings, a potential concern from investors in WHF (and BDCs generally) would be their exposure to floating rate assets. Again, part of our investment thesis centers on the view that yields are collapsing, making BDC yields even more compelling. However, if yields are declining, WHF/BDCs will likely face downward pressure on their NII as portfolio companies refinance at lower interest rates.

We concede there will unquestionably be pressure on NII under our “yield starved” thesis, but WHF can off-set some of this pain through its LIBOR floors; per their release “… nearly all performing floating rate investments having interest rate floors.” The ability to negotiate floors (mostly set at 1.0%) provides WHF a decided advantage over floating rate mutual funds, which largely populate portfolios with broadly syndicated loans for which floors have become non-existent.

Source: LCD

WHF’s liabilities also provide an offset if rates continue trending lower. The company’s Credit Facility—which represents roughly 75% of its debt obligations—is priced at LIBOR +275bps. The lack of floor on its most significant liability means shareholders would benefit from any potential basis differential if (when) LIBOR drops below 1%.

Using 4Q19 (ended 12/31/2019) as a point of comparison, we see that LIBOR have already fallen dramatically from the average of 1.93% during the quarter. As illustrated in the table below, as LIBOR declines below 1.00%, some of the rate-driven losses will begin to reverse as interest expense continues to decline whereas interest income ceases to fall given LIBOR floors.

Further mitigating rate pressure will be WHF’s new JV investment with STRS (as described by ele2996), which management targets generating levered yields in the 12% to 15% ballpark (vs. portfolio WAY of 10.4% today). Additionally, putting more capital to work per dollar of equity will further boost yields; WHF currently operates at 0.96x, below its leverage target of 1.0x to 1.25x.

Outside of the rate environment, investors may also object to WHF/BDCs given the risk that “the cycle is turning” and therefore defaults should spike. Again, despite recent foot-faults on AG Kings and Grupo Hima, WHF has an excellent track-record of avoiding bad loans. Additionally as StackPath demonstrates, WHF, as part of the broader HIG platform, has done a commendable job of “working out” bad investments.

WHF’s portfolio allocation will also help the company weather a protracted downturn. Currently 81% of the portfolio is 1st lien and 11% is 2nd Lien while only 3% is equity. The company continues to migrate up the quality curve, with 13 new 1st Lien investments last quarter.

In the current backdrop, with spreads around 500bps, under the formula default probability = (credit spread)/(1-recovery), the High Yield market is currently pricing in a default probability of 8.3% (assuming the long-term recovery rate of 40%).

Applying similar math to WHF, at a 10.5% dividend yield, we would argue investors are earning at least 950bps spread (grossly simplifying Treasuries rate of 1.0%). Even if we assume a 60% recovery (well below loan’s long-term recovery of 80%), WHF is currently pricing-in 23.8% default probability. By that math, investors are more than adequately being compensated for the cycle risk in WHF.

Additionally, the world is obviously influx right now due to uncertainty related to the virus. BDCs provide debt capital to small-and-medium sized U.S. businesses. Their underlying portfolio companies are, by definition, largely domestically focused and therefore should be less vulnerable to international trade-related disruptions. This is not to suggest portfolio companies will be immune (virus pun intended)—there could be supply chain related disruptions—but they should prove relatively resilient.

Catalyst

Market panic subsides 

Rates continue treding to zero, further improving the relative value