Email us with questions or comments: nmarshi.bdcreporter@gmail.com           α

WhiteHorse Finance: Good News On Aretec Group Recovery

BDCs:
Premium Free

NEWS

Back in 2014, White Horse Finance (WHF) made a Second Lien loan to brokerage firm RCS Capital Corp, which topped out at $20.7mn in the IIIQ of 2015.

Shortly thereafter, the borrower ceased making loan payments and then filed for bankruptcy.

The firm was involved in a high profile fraud case, outlined briefly here.

In 2016, a restructured and renamed company emerged from a pre-packaged bankruptcy process.

The trade name of the affiliated brokerages was changed to Cetera from Aretec.

As part of the restructuring, the lenders to the failed parent company received a reported 80% of the new entity, including WHF.

The second lien debt was written off in the debt for equity swap.

The BDC wrote down its position by as much as (65%), besides losing $2.5mn in annual Investment Income since the IVQ of 2015.

At the time, this was a major set-back for WHF whose 2017 annual Net Investment Income is $26.2mn and whose paid-in capital at the end of 2016 was $272mn.

Since the restructuring the renamed firm has managed to perform well.

The BDC has been able to write up its equity stake to $17.3mn as recently as the IVQ 2017, a (16%) discount over the original cost.

Now the financial firm has been placed on the block and multiple buyers are circling.

The current front runner to buy Cetera/Aretec is Lightyear Capital for a price mentioned in press reports of $1.5bn.

Here’s an article that describes the full history of Lightyear – a prior owner of the firm – with Aretec.

If a sale goes through, WHF is likely to receive proceeds at least equal to the value at year end 2017, or potentially higher.


ANALYSIS

WHF on its last Conference Call was already anticipating being able to re-deploy proceeds from a prospective sale into yield bearing investments.

Here’s what was said on this subject on the March 3, 2018 Conference Call:

So in the bankruptcy and restructuring of RCS with the resulting company being Aretec, the lenders in aggregate, first-lien lenders and second-lien lenders ended up with 80% ownership in the company. We had a position in the second-lien loan, which has given us the shares that you see. We are a significant holder, but not a majority holder by any stretch of the imagination, and we do not have any direct control at all on the decision regarding disposition of the company or the sale of the company. So we are tracking performance. We are — we believe appropriately reflecting value quarter-to-quarter. And at some point, which we can’t predict, we expect the company will be sold. And when the company is sold, then obviously, our position will convert into cash. And as I was stating earlier, that cash will be able to be reinvested, which will help with dividend coverage for us going forward.

If we assume receives proceeds equal to its stated investment cost and re-invests at the current average yield of 11.9%,the pro-forma increase to Net Investment Income would be between 8%-10%.

(Some of the increase to the bottom line will be reduced by higher Management and Incentive Fees).

If the sale happens and the funds are immediately re-deployed, the impact is likely to register in WHF’s books in the IIIQ of 2018 at the earliest.

Moreover, if the equity is sold at par WHF will be able to record a $0.17 per share increase in Net Asset Value Per Share, from $13.98 to $14.15 – all other items held equal.


VIEWS

The Aretec investment – despite the initial setback – promises to have a Happy Ending and gild a credit record that has been one of the best in the BDC lower middle market space.

At year end 2017, WHF had raised $302mn over the years in equity capital and recorded under $1mn in Realized Losses, and was carrying ($7.8mn) of Unrealized Depreciation.

When we reviewed the portfolio recently, we noted only 4 investments on the BDc Reporter’s Watch List.

Outcome Health

One of the biggest question marks has been Outcome Health, a medical advertising company embroiled in another alleged fraud and a major dispute between its principals and equity investors.

However that “disagreement” has been resolved of late and some portion of the Company’s debt paid down.

We have a Credit Rating of 3 on the $13.7mn First Lien loan and no immediate worries that there will be any non accrual.

Grupo Hima

More problematic is the situation at Puerto Rico Hospital chain Grupo Hima San Pablo.

WHF has provided mostly first lien financing and $1mn of second lien.

We’re a little confused as to what is happening at the stressed hospital company.

This is a credit in which multiple BDCs are involved.

Stellus Capital (SCM) has placed its Second Lien position on non accrual from November 1, 2017

KCAP Financial (KCAP) , Main Street (MAIN) and WHF have not.

WHF’s latest 10-K had the following to say about the hospital loans:

Like many businesses in Puerto Rico, our portfolio company Grupo HIMA San Pablo, Inc., or Grupo HIMA, has been adversely affected by Puerto Rico’s troubled economy, including high unemployment, population decline and high government debt.Grupo HIMA’s management engaged an adviser to explore financing and strategic options designed to improve its finances and operations. We are monitoring the status of Grupo HIMA’s operations and the impact of this strategic review on our investments in a first lien senior secured loan and second lien secured loan issued by Grupo HIMA. As of December 31, 2017, the fair value of our investment in the first lien senior secured loan was approximately $12.4 million, and the fair value of our investment in the second lien secured loan was approximately $0.2 million.

We have a Corporate Credit Rating of 4 for Grupo Hima and are not optimistic about the chances of full recovery for the junior debt, based on the valuations we’ve seen and what little we’ve been able to learn.

For example, MAIN has written down its Second Lien debt exposure by (90%) and SCM by (78%). WHF, too, has written down the more junior debt (78%).

The First Lien Senior debt, which was due in January of this year, is likely to be extended but the prospect of default or a major loss is more remote.

Still, at worst, WHF could lose up to $1.7mn in annual Investment Income should Grupo Hima falter.

The second lien exposure at FMV is relatively modest at $0.239mn, or just 1 cent a share potential negative impact to book value.

Caelus Energy

The other Watch List name is Alaska focused energy company: Caelus Energy Alaska O3, LLC.

WHF has a $13mn Second Lien Term Loan to the oil and gas exploration & production company.

This is a credit shared with CM Finance (CMFN), which has a big focus on energy-related borrowers, and which is also invested in the second lien loan.

As you can imagine, even though the Caelus debt has remained performing through the oil price drop period, the valuation has suffered at times.

As late as IIIQ 2016, the debt was carried at its highest discount to cost: (28%).

However, with the rebound in the price of oil, so have the valuations at both CMFN and WHF.

The former has a discount of (7%) at year end 2017 and WHF a more “conservative” (17%).

The short term trend for value remains upward which might contribute to a slightly higher NAV in the coming quarter(s).

Risk Profile

The BDC Reporter does not limit itself to looking only at Watch List companies.

We look at the overall risk profile of any BDC’s investment portfolio and its balance sheet.

In this regard, WHF – which came public in 2012 – is in pretty good shape.

The lower middle market oriented BDC has $441mn in total investments, and $35mn in cash.

There are 43 companies in a relatively well diversified portfolio and – as we’ve seen- only 1 in 10 is on our Watch List.

If we use WHF’s own 5 point rating system, there are virtually zero dollars in the two lowest categories both in 2016 and 2017.

However, WHF does carry $70.8mn in Category 3 up from $53.5mn the year before.

That’s slightly higher than the BDC Reporter’s aggregation of the 4 Watch List names mentioned above.

Amongst the 39 companies not on our Watch List about 20% are in loan arrangements either heavy in PIK or charging over 12.00% per annum, or both.

These high priced loans serve as early red flags, but WHF’s exposure is relatively moderate and has a demonstrable track record of handling these higher risk borrowers.

We do shudder a little when we hear about the multiple non sponsored loans that WHF books and keeps us vigilant.

We’re partly reassured by the Investment Advisor’s policy of seeking to keep “hold positions” in any individual loans under $20mn., a goal violated in just 4 instances.

Thumbs Up

From a liability and liquidity management standpoint, WHF is in very good shape at the moment.

That’s partly due to raising new equity in 2017 (and the reason why cash is so high).

Asset coverage (including the cash) of total debt is 255%, higher than the year before.

Of the $185mn debt outstanding on the balance sheet, $155mn is due to the BDC’s bank lenders and another $30mn is in the form of Unsecured Notes.

Neither facility needs to be repaid or refinanced any time soon: the Revolver till 2021 and the Baby Bonds till 2020.

When the latter does get repaid, we expect borrowing costs will drop.

We may also see an increase in Unsecured Debt given the new BDC leverage rules.

Conclusion

WHF appears poised to recover most, all or more than its original investment in Aretec and come out of its worst credit misstep since becoming a public BDC smelling of roses.

That – by itself – could materially boost earnings and – to a lesser degree- book value later in 2018.

However, the Credit Gods often giveth and taketh away so shareholders will have to keep an eye on what happens at Grupo Hima San Pablo, and in the portfolio more generally.

Otherwise, the BDC’s credit portfolio looks to be in pretty good shape early in the year.

The BDC’s overall risk profile remains well within what we’re capable of tolerating.

Likewise, liquidity is in good shape and should only be improved if the Aretc equity gets repaid and re-deployed.

Barring any unexpected surprises – and assuming both the Aretec sale goes through and Grupo Hima does not implode – 2018 is promising to be a good year for the BDC.

We are projecting Net Investment Income Per Share of $1.42, up from $1.35 in 2017, which was impacted by the secondary equity offering.

That is in line with the current annual distribution of $1.42, unchanged for 21 quarters in a row.


INVESTMENT DISCLOSURE

At time of writing WHF was trading at $12.8 (Friday March 23 close) and yields 11.1%.

The stock is trading at a discount to par of $13.98 and 9.0x the BDC Reporter’s projected earnings and 9.5x 2017 earnings.

The 52 Week Low was $10.92 and the High $15.05.

Our Positions

We are Long WHF’s common stock and Baby Bond (WHFBL).

Common Stock

We bought the common stock in February 2018 in two lots at prices of $11.66 and $11.96 in our Special Situations strategy. 

Our average cost is $11.81.

We bought the stock when WHF slumped in price from a high of $13.36 in January of this year to a low on March 1 of $10.99. 

In addition, we own WHF in our Long Term Income portfolio. We began accumulating the stock back in November 2017, and added during periods of price weakness.

The average cost is $12.48 and WHF yields 11.4% at cost. 

Our 5 Year Total Return estimate is 50%, or 10% per annum at our cost  (9.4% per annum at the current price). 

We assume an Exit Multiple of 10.5x 2022’s dividend, in line with the recent 52 Week High. 

Fixed Income

Currently WHFBL trades at $25.50. 

We own WHFBL in two different portfolios, and both for a long time.

Our average cost in our Fund is $25.2742 and the yield 6.42%.

The Baby Bond has traded in a relatively narrow range, as this chart shows.

Already a Member? Log In

Register for the BDC Reporter

The BDC Reporter has been writing about the changing Business Development Company landscape for a decade. We’ve become the leading publication on the BDC industry, with several thousand readers every month. We offer a broad range of free articles like this one, brought to you by an industry veteran and professional investor with 30 years of leveraged finance experience. All you have to do is register, so we can learn a little more about you and your interests. Registration will take only a few seconds.

Sign Up