I have initiated just one new position in my portfolio in the second half of 2020 to date, in spite of the wild swings throughout the market. This low activity is in contrast to the first half of the year, when I added Brigham Minerals (MNRL) in the oil and gas sector, AXA (OTCQX:AXAHY), a global property and casualty insurer, Park Aerospace (PKE), Walgreens Boots Alliance (WBA) and Newell Brands (NWL) in retail, and media player ViacomCBS (VIAC). However, there has only been a single addition since July 1st, Horizon Technology Finance (HRZN).
For those not familiar with Horizon, it is a business development company [or BDC for short], providing young ventures with financing – in Horizon’s case, generally in the form of debt. BDCs can give retail investors access to investing in firms that might otherwise be restricted to accredited and institutional investors, with the associated riskiness expressed in the above-average yield in dividends (currently 10% yield) back to shareholders, while also providing some breadth and diversification. In Horizon’s case, it has provided some $2 billion in venture financing since 2004 to more than 200 companies in technology, health care, sustainability and life sciences sectors. Through the steady payouts, shareholders in Horizon have reaped the benefits. While it has not outperformed the broad S&P 500 (SPY) over a ten-year or five-year span, it has held its own just fine for the past 3 years on total return basis, and has managed to do so for extensive stretches – it has outperformed the index more than half of the time over that window.
The intent here is not to cherry-pick data points that make Horizon look good, but only to demonstrate it has been well-managed enough over a long enough stretch to at least market-perform, as well as show the significance and potential of that high dividend to keep pace with capital gains.
Looking Over Horizon’s Horizon
Quite a bit has transpired with Horizon over the last quarter, so a brief review is in order. Of first note, most BDCs like Horizon are also a “registered investment company” [or RIC for short], which is a favorable legal tax status that requires it to distribute 90% of its ordinary income annually to shareholders. For Q3, Horizon reported net investment income of $0.34 per share, out of which it paid $0.30 to its shareholders ($0.10 per month). That income resulted from the faithful debt and interest payments received from its venture clients, including a handful that were in positions to prepay and extinguish their obligations. In fact, prepayments outweighed new origination by more than two to one – $43 million in prepayments to just $16 million in new loans.
Management admitted openly that the level of prepayments during the quarter caught them off guard, and between the prepayments and an “at the money” capital raise of $13 million, etc., Horizon had $57 million in cash available at the end of the quarter for making new investments, with an additional $47 million in credit lines available. Since the close of the quarter, it has announced a $25 million loan to car share venture Getaround, so by rough estimate it has $75 million to $80 million in cash still available, depending on any others that were in the Q4 pipeline getting done at this point. Gerald Michaud, Horizon’s president, indicated on the earnings call on November 2nd that there was $96 million of committed and approved funding in the company’s backlog, some 60% of which was dedicated to the existing life science part of the portfolio.
I am in no position to scrutinize individual deals the company makes – I trust their management and team vet the opportunities according to their own standards. However, this is a higher-risk sector, and not every venture will succeed. During 3rd quarter Horizon moved a few accounts to non-performing, which resulted in part reducing the NAV per share to $11.17 from $11.64 at the end of Q2. Clearly, with the shares trading around $12, there is no discount to NAV offered here, understandably a point of caution for investors concerned about overpaying. The premium probably boils down to some combination of factors of the steady income (monthly distributions have been paid for 4 years, and the next three months have been approved and declared), along with the potentially lucrative nature of the underlying investments in the portfolio companies.
Horizon is by design high-up in capital stack of its portfolio companies and often sitting on additional warrants that can pay out nicely in the right cases. In fact, beyond the interest and principal payments received during the quarter, warrant positions in the companies have translated to $7.9 million year to date, relative to $32.3 million in interest income through the first three quarters. The other part of the reality, however, is that the ventures that do not work out also can become less liquid. This was the case with IgnitionOne, a digital marketing company that crumbled and sold itself off ultimately, and now Horizon’s loan is secured effectively by private shares of what remains with no quick or easy way for them to convert to cash and get repaid.
The portfolio companies – evaluating the risks
The first thing to note about the stable of companies in which Horizon has an interest is that there are currently over 100 names in the portfolio. However, this is concentrated overwhelmingly in debt positions in 34 companies, with warrants in some 60 others, but those represent only 3.3% of the portfolio’s value.(image source)
Horizon’s debt terms to those companies are at high interest; the yield on the debt portion of the portfolio is over 15%, but new debt was being issued closer to 11%. It is no surprise, as interest rates have fallen across the board, that this blended figure on the full loan book was closer to 17% a year ago. The companies have other sources of cash – investors, their own operations, perhaps others creditors, and the majority have the cash they need through 2021 and continue to be able to raise cash, which makes Horizon’s loans more secure. There is more in it for Horizon than the loans, of course, as Horizon sometimes will take an equity stake, or buy in on the previously mentioned warrants, but further deterioration in interest rates could conceivably lead Horizon to tilt the portfolio slightly more towards the equity and warrants positions in the future, so it is something to keep an eye on.
Regardless of the overall quality of the portfolio, the potential for a couple of ventures to fail and really damage the portfolio should be kept in mind. For example, the $25 million loan mentioned earlier to car share venture Getaround is a deal worth more than all of the company’s third-quarter deals combined, and represents around 8% of the current loan book (per Horizon’s website, $25 million is the largest loan they will do). Clearly a big miss here, for example, would take a real bite of the NAV. Fortunately, most loans are not this significant; the average loan value is less than $9 million, or 3% of the total. In fact, Getaround seems to be the largest single deal Horizon currently has in place. From my review of the Q3 10-Q report, the next largest loans were for $20 million, with all three of them coming due in 2024: Castle Creek Pharmaceutical Holdings due in March, CVRx, Inc. due in October, and Updater, Inc due December.
On the whole, related to the loan portfolio, the life sciences fair value stood at $147.8 million, technology loans were $130.6 (as valued before the Getaround loan), with one loan portfolio company categorized separately from life sciences as health care information and services with $14.8 million in loans. The breakout I think shows a reasonably even split between life sciences and technology ventures. In the life sciences, investors are dealing with risks of high research and development costs with uncertain outcomes, FDA approval process, and ability to prove and communicate efficacy enough to generate sustainable sales. The risks on the technology side are somewhat the opposite – fairly low development costs, making potential disruption and competition cheap, so establishing market share and some customer loyalty is more critical.
Horizon rates the quality of its loan assets each quarter based on financial health and risk of non-payment, and I imagine most investors do something similar in ranking investments along some internal metric of low risk to higher risk. I mark my personal portfolio of securities as either low, moderate or high risk, which primarily means to me the risk of not breaking even given my time horizon for holding the shares. These ratings are relative to one another and subjective; these are not based on any strict quantitative inputs or screens on my end. I admit I don’t review or update the ratings as I should, and decisions have a tendency to get thrown into the “moderate” rating as a catchall. For example, my largest holding, Royal Dutch Shell (RDS.B) (RDS.A) I had rated “low” when I first bought in, and I am down 25% on paper right now, and should probably have been rated as “moderate” instead like my other energy holdings. On the other side, I have Horizon, my smallest position, rated “moderate” but given the underlying risks in its loans, it may merit a rating as a higher risk investment in my portfolio.
I bring this up only because while I am relatively new to owning a stake in Horizon, frankly it fits in on the higher end of my risk appetite. The fundamental attractiveness here is translating that higher risk into steady returns each month that are currently yielding around 10% (my first dividend payment hit my account earlier this week, that gives some idea of how recently I entered the position), while keeping my overall exposure to a level I am comfortable with. I currently only have around 10% of a full position, and will continue to take a wait-and-see approach, but my current best guess is that I would stop at half a position max, and only build that up quite slowly, over the next 12 to 24 months. With appropriate cautions in place, I like Horizon Technology Finance for income.
Disclosure: I am/we are long HRZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.