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Horizon Technology Finance: Issues New Baby Bond

BDCs:
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On September 26, 2017 Horizon Technology Finance (HRZN) announced its intention to issue a new Baby Bond. The following day the new issue was priced. The BDC News Of The Day provides the key details from the related Prospectus and press releases; analyzes the impact on the BDC’s income statement and balance sheet and discusses how the new offering fits in with the sustainability of earnings and the distribution. We end – as always – with a discussion of how we are approaching investing in HRZN’s common stock and debt. We launch- as an attachment at the top of the page – our disclosure of all of the BDC stocks and bonds we own.


NEWS

The new Baby Bond will mature September 15, 2022 and totals $32.5mn.

The underwriters may be granted an additional $4.875mn, which could increase the balance to $37.4mn.

The yield on the Notes will be 6.25%, payable quarterly beginning December 15, 2017.

The Baby Bond may be redeemed – at the option of the issuer – as early as September 2019.

The proceeds will be used to repay the existing Baby Bond outstanding with the ticker HTF, which has a balance of $33mn and bears a coupon of 7.375%.

The cost of the debt raising, based on the net proceeds, was $1.2mn.


ANALYSIS

Comparables

HRZN has been able to raise this new issue at a price close to what other smaller BDCs have achieved for a medium term unsecured note.

Harvest Capital (HCAP) and KCAP Financial (KCAP) has both just issued 2022 Baby Bonds at a yield of 6.125%. Both were covered by the BDC Reporter. See here and here.

Interest Savings

The pro-forma annual interest savings from the reduction in the Baby Bond interest rate will be $0.371mn, or $0.5565mn till the nominal maturity in March 2019.

However, the new funding will  total expenses of approximately $1.5mn ($1.2mn of placement expenses and a projected $0.3mn of other related costs).

Those costs will probably be expensed over 5 years at $0.3mn a year.

Furthermore, an undetermined amount of un-amortized expenses from the premature repayment of the existing Baby Bond will be booked in the IIIQ 2017 results.

If the underwriters exercise their over-allotment the interest expense on the new Notes will be only $0.100mn lower than the current Note due to the larger amount involved.

Secured vs Unsecured

With this issue, the gap between what HRZN can borrow on a secured basis from its Revolver lender (Key Bank) and on an unsecured basis has narrowed to 1.85%.

Revolver rates are increasing with LIBOR (and HRZN borrows at the lowest rung of 1 month LIBOR) increasing and – as we’ve seen – unsecured debt decreasing .

If the Fed does raise rates as expected in December and follows up with 0.75% in multiple increases next year, the gap may narrow to under 1.0%.

Minor Impact: Earnings

However, the new lower rate on the Baby Bonds – which on a pro-forma basis should increase Net Investment Income Per Share by 3 cents a year – is unlikely to affect recurring earnings or the dividend much.

First, the cost of raising the new debt and writing off the old should in the short term be far greater than any interest expense savings.

BDCs typically add-back these costs when discussing recurring earnings but with most debt facilities lasting such short periods that’s not necessarily appropriate.

Second, as we’ve shown, the issuance of the over-allotment will result in more expensive debt being raised and paying down the Revolver initially.

Third, HRZN is currently deferring a portion of its Incentive Fee, which may get paid to the Investment Advisor in the future.

Minor Impact: Balance Sheet

From a balance sheet standpoint, not much has changed with the issuance of the new debt.

As before, the preponderance of the BDC’s debt outstanding will be in unsecured form (59% at June 30 2017).

Given the low advance rates which the Revolver lender is prepared to advance against HRZN’s venture investments, the BDC will continue to lean heavily on the Baby Bonds for its borrowings.

At June 30, 2017 HRZN had $179mn in portfolio assets, but only $23mn was drawn under the Revolver and maximum potential borrowings (including existing outstandings) $60mn.

Although Key Bank nominally lends 50% against HRZN’s loans, borrowing base limitations and exclusions effectively means maximum borrowings could not exceed one third of those assets.

Given that HRZN has to maintain availability to fund undrawn lines to existing borrowers (a nominal but unlikely $30mn), the BDC Reporter does not expect the Revolver to get drawn consistently much above $40mn of outstandings.

Overall, HRZN’s debt funding should be roughly equal between secured and unsecured forms.


VIEWS

Had To Be Done

With the maturity of the existing Baby Bonds only a year and a half away, and market conditions for BDC fixed income issuance very favorable, HRZN did what they had to do.

(We had been hoping – in our capacity as holders of HTF that this might happen early next year, but that was not to be).

Of course, the nominal interest savings were also a factor in the refinancing.

Only So Far

However – as we’ve tried to show in the Analysis section – borrowing on an unsecured basis is an important part of HRZN’s business plan because the amounts that can be borrowed on a Revolver are limited.

Loans bearing a 14%-15% yield may be attractive to HRZN’s shareholders – even if much of that yield is in non-cash/deferred form – but don’t make the most attractive collateral for Revolver lenders.

Big Brother’s Example

To a large degree that other venture-lender Hercules Capital (HTGC) has eschewed any long term borrowing under its bank Revolvers and utilizes unsecured debt as its primary form of leverage.

With the shrinking of the differential between borrowing secured and unsecured we wouldn’t be surprised to see HRZN seek to raise more Baby Bonds or equivalent in the future if the BDC is able to grow portfolio assets again.

Like at HTGC, the Revolver may become more of a “swing line”, to be “taken out” from unsecured note proceeds or (if things really change) equity offerings.


DIVIDEND OUTLOOK

The BDC Reporter evaluates the sustainability of every BDC’s regular distribution. (Premium subscribers will soon receive a link to our Dividend Outl0ok Table)

In the case of HRZN, since August 5th 2017, we’ve rated HRZN as most likely to Decrease its dividend within the next twelve months (by August 2018).

To date, HRZN has announced an unchanged $0.10 a month/$1.20 a year distribution through November 2017 (using the ex-date).

Judging by the stock price movement in recent weeks (going from $10.0 a share to $11.0 roughly) and with a yield of 10.9%, the market seems to be becoming less concerned about a potential dividend cut.

Some investors may have foreseen (or heard on the capital markets grapevine) about the new issue and pre-emptively bucked up the stock price.

(Another wild card is what is happening in the background with HRZN’s portfolio, and the 6 of 37 companies rated as being in some sort of credit trouble).

Conclusion

Notwithstanding all the above – and after another review of the latest financials and the Prospectus just in case – we continue to be skeptical of HRZN’s dividend sustainability within the given time period.

We refer readers to our August 5 article for all the arguments, none of which have materially changed.

The BDC Reporter may be wrong, or just early, but we stick with our projection that HRZN’s $1.20 a year distribution is likely to be reduced (probably to $1.0 or less a year).


BDC INVESTOR: INVESTMENT STRATEGY

Common Stock

We have no position in HRZN’s common stock either in our Long Term Income or Special Situations strategy.

Regarding the former, HRZN’s historic performance and business model do not inspire us to invest for the long term, as we foresee a trend of ever diminishing earnings and pay-outs in the years ahead.

Furthermore, we are concerned that nearly a third of all income is derived from 5 of the 37 companies in the portfolio and that – unlike HTGC – the BDC has not been able to demonstrate the ability to offset credit losses with equity gains despite a very favorable environment in the years since going public in 2010.

However, HRZN does figure in our Special Situations Watch List, and has for weeks, due to the uncertainty about its distribution, which is reflected in the volatility of the stock price in this YTD chart.

With the price going up when our Dividend Outlook is down, we’ve chosen to stay un-invested.

Fixed Income

We have a Long position in the current Baby Bond (HTF), and had hoped – as mentioned above – this refinancing might happen next year.

Instead HTF dropped from a price of $25.42 to $25.15 after the announcement was made of the refinancing.

(At the end of August HTF was at $25.45 and has traded as high as $26.10 in the last year).

Our average cost was at $25.3156.

We will probably hold onto the position till redemption to collect all remaining accrued interest.

Our annual yield at cost has been close to 7.3%, which we’ve been earning for several years, so we have no regrets as having stayed a little too long.

If we sold all BDC Baby Bonds at risk of getting redeemed early we’d have to sell half of our portfolio…

Re-Invest ?

Given the low yield and our concerns about HRZN, we have not yet decided if we will re-invest in the new Baby Bond.

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