Horizon Technology Finance Corp
NASDAQ:HRZN
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Earnings Call Analysis
Summary
Q3-2023
Venture capital funding hit a 9-year low at $9 billion in Q3, yet exit markets show promise with $36 billion in value, led by two prominent IPOs. Horizon's cautious approach to investment, amidst challenging conditions expected into early 2024, means safeguarding current portfolio values. With over $1 billion in advisory pipeline opportunities and $227 million backlogged, Horizon is poised for prudent growth. Q3 results witnessed a 25% year-over-year increase in investment income to $29 million, yielding $0.53 per share in net investment income, covering distributions amply. The company declared monthly distributions of $0.11 per share for Q1 2024, with a special distribution of $0.05 per share in December 2023. The net asset value per share decreased to $10.41, attributed to distributions, realized losses, and fair value adjustments. With 95% of its debt portfolio set to benefit from rising prime rates, Horizon is strategically positioned for future gains.
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Greetings, and welcome to Horizon Technology Finance Corporation Third Quarter 2023 Earnings Call.
[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.
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 31st, 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.
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 adviser Horizon Technology Finance Management and its experience and expert team remain focused on our portfolio's 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 adviser. Dan will further discuss the impact of incentive fees on NII in his remarks.
Based on our outlook in our undistributed spillover income of $1.23 per share as of September 30th, 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 30th. 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?
Thanks, Rob, and good morning, everyone. Our portfolio grew slightly from the prior quarter to $729 million as of September 30th, 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 8 debt investments totaling $88 million, including debt investments to 4 new portfolio companies and 4 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 remain 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 1 loan prepayment, 2 refinanced loans, and 1 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 and M&A markets. Our debt portfolio yield of 17.1% continues to validate structuring our investments with floating interest rates and a rising interest rate environment. We again generated one of the highest debt portfolio yields in the BDC industry. As of September 30th, we held warrant 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, Double Biosciences had 2 unfavorable trial outcomes during 2023, including a failed Phase IIa trial for its psoriasis drug, 29 23 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 continue to diligently work towards achieving additional recoveries on our investment.
Subsequent to the end of Q3, Horizon received an additional cash paydown of $11 million for 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 30th, 87% of our debt portfolio consisted of three 4-rated debt investments compared to 90% as of June 30. Our five 2-rated debt investments at September 30th 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 and 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 ideal market in our 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 9-year low, while the avenue to public exits is still largely closed. VC's committed capital from their LPs remains elevated 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 [ Extacart ] 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 historical lows during Q3. There was 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 4 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 a 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 by 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 to the 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 advisers 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 there 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.
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 continue 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 30th, we had $80 million in available liquidity and consisting of $47 million in cash and $33 million of funds available to be drawn 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 30th 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 30th 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 investment.
Our debt investment portfolio on a net-cost basis stood at $117 million as of September 30th, a 2% increase from June 30th, 2023. For the third quarter of '23, 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 '22. 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 incentive fees otherwise earned by adviser 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 '23 was $0.53 per share compared to $1 per share in the second quarter of 23 and $0.43 per share for the third quarter '22. The company's undistributed spillover income as of September 30th 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 prepayments 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, refinancing 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 30th, 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 30th was $10.41 per share compared to $11.07 as of June 30th, 2023, and $11.66 as of September 30th, 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, their 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.
Thank you. [Operator Instructions] The first question comes from the line of Bryce Rowe with B. Riley Securities.
Let's see, I 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.
Good morning, Bryce. Just 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. So, nothing certain today.
That's helpful. 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. One 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?
This is Jerry. So as it relates to Nextcar, that company does continue to raise capital in the marketplace. And there they would be in an interesting position if there were better exit markets. And that was their expectation along with a lot of other companies, VC-backed companies, with the exit markets just not there for them. So they continue to raise capital, continue to get inside support from investors and they're in a very dynamic market there in the car kind of subscription, rental business, and it is a growing platform. But until 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 them get to a better exit opportunity, and that's kind of where we are.
And then, Danny, if you could just touch on Nexii building as well.
Nexii kind of similar situation, very interesting product, good demand for their product, difficult markets 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, it would be opportunities for this company to do something a lot more exciting. But right now, they just continue 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 in how they're thinking about financing the business.
Excellent. Thank you for the commentary. I'll hop back in queue for some others to take a chance. Thanks.
Next question comes from the line of Christopher Nolan with Ladenburg Thalmann.
For Evelo, were there any incremental investments made in the fourth quarter?
No, no.
And on the call, you said there was $16 million of repayments in the third quarter.
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 paydown 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 that 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.
And then I saw on the Q that for Evelo, you also marked down your equity positions. Do these pipe transactions, should we expect further write-downs in equity from your perspective? Or do you think insiders stepping up will stabilize your equity investment?
Yes, I think we actually have a note in our Q that we filed a subsequent event that we believe that we will be marking down the equity in the fourth quarter as well.
And then I guess a follow question. Were there any new nonaccrual investments in the fourth quarter?
So from the third quarter, there were a couple of different names, and you can see them on the scheduled investments, the names that are on nonaccrual and they were new names. One name dropped off and a couple of names did get tagged as nonaccrual for the quarter, Evelo being one of them and Robin being another.
Yes, I'm asking for the fourth quarter to date.
Fourth quarter to date, no.
[Operator Instructions]. Next question comes from the line of Ryan Lynch with KBW.
Following up on Bryce's question on Nextcar and Nexii. I don't want to necessarily lump these investments together because there are 2 different situations. But I had kind of similar questions on both of those. Number one, I think you -- I believe you said they are both continue to be funded -- internally funded. I guess what does that mean? Because I would assume that both of these are still negative cash flowing businesses.
So I would just love to hear what exactly that means. And then also what drove the decline in fair values for these businesses? Because it sounds like the way you describe them, both -- and again, I know they're different companies, but kind of the way you describe it both, is that the fundamentals of the business seem to be doing fine or maybe as expected, but the exit opportunities have certainly deteriorated just given market dynamics. So was the weakness and the potential of kind of overall exit markets, the driver of the decline in valuation or was something else moving that lower this quarter?
Honestly, it is a little bit exit markets and opportunities to fund the growth that would otherwise might be available to them. So in other words, they are operating okay. They are -- again, the investors continue to support the companies to a degree, but really outside capital is needed in some form or shape, meaning public offering and M&A or a large venture capital or crossover fund, I think, in probably both of these cases.
And so they're working -- that's where they're spending a lot of their time right now. It's on trying to find that right exit opportunity in a market where exit opportunities are really difficult. And so they're getting funded because the investors see that there is value in the company. and the potential for a positive exit still certainly exists. But they -- I think this isn't just -- these 2 companies, I think, across the venture capital community most companies really are spending in an inordinate amount of time figuring out fundraising strategies.
I think we provided some data on venture capital fundraising in the third quarter. Again, it was down fairly significantly. Part of the issue is that many of the companies that were funded in 2020, 2021, certainly first half of 2022, the valuation of those companies is -- in this market, they are significantly overvalued. And so it's hard to bring in new investment or attract new investment in that kind of scenario. So where there may be operationally growth opportunities, it's difficult to take advantage of those when capital is so constrained.
And so to get -- maybe to get to the last part of your question. So not knowing when those markets are going to turn, we have to be, as we're looking at our debt investment, we have to be very sober about what happens if those markets continue to be as tight as they are, meaning exit markets and VC flows. We have to be very sober about how we value these assets.
So it's primarily related to the exit markets and just the ability for these companies in the specific industries that they're in to fund operations, but not necessarily anything going on specific with these businesses deterioration? Is that a kind of a simplified version of what we're talking about?
Yes, very simple because the fact of the matter is when it is difficult to raise capital, it is difficult for companies to make operational decisions based on the need for additional capital that may not be there. So that does impact your ability to make -- which in a good market would be pretty straightforward operational decisions, it makes it more difficult to do that. And that -- again, that's just not just about these 2 companies. That's across the board.
And then the other question I had was on Evelo, obviously, a disappointing outcome with that, thus far. I'm just curious, as you kind of look back on that investment, I understand it's still kind of an ongoing investment, but as a lot of the, a lot of the results have already taken place at this point. What lessons have you learned from that investment, specifically that will inform your decisions going forward on how you invest in? And then kind of a second part on that, that was an investment that was a pre-revenue position in the life sciences area that was reliant on these clinical trials, the approval as well as I know you guys had a big majority supporter in that investment. But what percentage would you say of your life sciences investments are pre revenues and reliant on clinical trials?
I don't have those exact numbers in front of me. But to get to the kind of core of your question, whenever we underwrite a life science company, it's a drug development company, obviously burn cash with ongoing clinical trials. What you look for is a broad-based technology platforms. You look for a pipeline that has not just one drug candidate addressing one indication. You look for multiple drug candidates addressing multiple indications. Those are all there when we underwrote the deal, and you also look for a strong investor base, which the company had. And I'm not -- I'm just -- I'm not trying to justify anything one way or the other. But historically, that's how we have always underwritten life science drug companies.
And generally, what happens is as these drug candidates move through clinical trials, the companies are able to raise more money, especially the public ones in the public market. and continue moving other drugs through the clinic. So even if one of them fails, there is still a broad pipeline. There is still numerous potential value in the assets. And to simplify this and really I'm simplifying it. The acceleration of how quickly each one of these clinical trials came to fruition, I think that was probably one of the things that we would look at. It's not just do you have a great pipeline, but where are those drugs in the clinical trials, it's not that we didn't look at that, maybe that should have been a greater focus. And it certainly should have been a greater focus, given what happened in the overall life science market over the last 4 quarters, where funding is literally dried up. And that includes IPOs. It includes follow-on equity for public companies. It includes VC investment. And a lack of big pharma buying up these companies, which is usually a primary wave that they end up exiting the market.
So yes, there are some things we're certainly going to look at here. We do have other life science companies in our portfolio. They're in drug development stages. None of them, as I sit here today, they all seem to be fairly well funded going forward other than IMV, which we've already focused on. So that is something we'll look at. Right now, where -- I got to tell you where we are laser-focused on helping the company try to create as much value as they can with their underwriting platform technology going forward. And I think, hopefully, by the end of the fourth quarter, we may have something more to report on that. But right now, it's very early in that process. They just announced 10 days ago that the -- they had -- their 29 39 drug for psoriasis failed, and they were going to look for strategic alternatives. So we're really early in that process.
One last one that I had. I think both in your prepared comments and your press release, you sort of talked about remaining selective in originating new investments in the remainder of 2023. I would assume that there's still really good deal opportunities out there, but I would assume that the -- kind of the comment on remaining selective is to reduce leverage levels at the BDC? Is that kind of what -- is that kind of the driver behind remaining selective is that you can kind of get leverage levels down to a lower level? And if that is the case, where would you like to see leverage levels ultimately end up at?
Well, let me just address it from the marketing side and then Dan may have some comments. From the marketing side, really, we have to -- you have to be really aware of where market conditions are right now, particularly relative to venture capital investment the kinds of companies that they venture capitalists are still investing in, they're still leaning forward on where are those companies, where are those markets. So you've got -- on the marketing side, you got that. And there are really good opportunities there because there are an exit -- really good exit markets for those kinds of companies. So companies that are performing really well, continuing to get -- attract capital -- that's fine. But we're -- anyone who comes into the market and says, we expect to be public next year, that's probably not -- if that's their goal, and that's their exit strategy, that's probably not something that in today's market, we would consider being interested in.
And I'll let Dan speak to the leverage side of this. But... .
As we mentioned, we are net of cash at 1.12. So that's below our target leverage. So we're comfortable where we are today. Being selective, I would agree with Jerry, it's more just on the market dynamics and the deals we're looking at.
There are no further questions at this time. I would like to turn the call back to Robert Pomeroy, Chairman and CEO, for closing comments.
Thank you all for joining us this morning. We appreciate your continued interest and support in Horizon. We look forward to speaking with you again soon. This will conclude our call.
This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.