Hadrian’s Wall Secured Investments Limited (HWSL) has announced its annual results for the year ended 30 June 2019. During the year, HWSL provided NAV and share price total returns of 2.3% and -4.4% respectively. The total dividend for the year has been maintained at 6p, while earnings for the year were 2.2p, down from 4.6p for the prior year. The chairman, David Warr, describes the 2019 financial year as a challenging one for the Company. He says that most of the Company’s investments continue to perform as expected, but that it has experienced setbacks within its portfolio. These are discussed further in the investment manager’s risk management review (see below).
The company also adopted IFRS 9 with effect from 1 July 2018 (discussed further below). IFRS 9 requires, among other things, the establishment of expected loss reserves based on modelling the expected loss of the portfolio. As of 30 June 2019, the Company had £5.2 million of IFRS 9 reserves. The Company currently has no case loss reserves because the Investment Adviser continues to believe that it will be able to recover substantially all of the value from the investments currently undergoing remediation. These investments, as with the rest of the portfolio, give rise to IFRS 9 expected credit loss reserves which the manager would expect to reverse upon repayment or recovery in full.
The report provides the following key highlights:
- At 30 June 2019, the Company had principal loan balances with an aggregate value of £153.7 million, net of repayments, with outstanding undrawn commitments of £5.6 million.
- Annualised portfolio gross yield on invested assets of 9.2%* on an effective interest rate basis for the year ended 30 June 2019 (30 June 2018: 9.2%*).
- Total dividends of 6.0 pence per Ordinary Share were declared and paid to Shareholders in the year ended 30 June 2019 (30 June 2018: 6.0 pence per Ordinary Share), and a further 1.5 pence per Ordinary Share was declared in July 2019 and paid in September 2019.
Investment manager’s commentary on portfolio activity
“During the year, the Company achieved one of its portfolio goals of being fully invested thereby reducing uninvested cash balances, which were dragging on the returns to shareholders. The Company entered into a £25 million liquidity facility which allows the Company to minimize the cash drag associated with uninvested cash balances.
The balance of the portfolio between individual corporate loans and pools of loans sourced from specialist finance companies and evaluated based on sets of analytical criteria has varied since the Company’s IPO. Based on the performance to date of the two categories of investments, the Investment Adviser is seeking to increase the proportion of pooled loan transactions relative to bespoke corporate loans. The two types of investments have different risk characteristics, with portfolio transactions having lower single event risk and less severity of loss given default. In light of the aggregate size of the Company’s investment portfolio, it is the view of the Investment Adviser that weighting the investments toward pooled transactions currently offers a better risk/return profile in the present economic environment.”
Investment manager’s risk management review
“Work-out and remediation are not uncommon in the sectors to which the Company lends, particularly considering the Company averages approximately a 9% average gross yield on its investments at a time when the base rate is less than 1%. The Company’s direct borrowers are typically businesses in transition with relatively volatile cash flows and are therefore expected to default more frequently than borrowers with greater financial strength and certainty of cash flows. Defaults and recoveries are a normal part of its business and a key reason the Company insists on security for its loans.
That said, remediation and work-outs were higher in this fiscal year than expected as certain of the Company’s investments were subject to unexpected operational and/or financial issues. Considerable amounts of the Investment Adviser’s efforts have been focused on remediating these investments. One of these situations is resolved and three others are in active remediation.
In October 2018, Arensis Energy Ltd, Entrade Energy Ltd and Arensis Energy One Ltd filed for administration. The borrowers operated pellet plants in England and Scotland. The English and Scottish assets of these companies were purchased out of administration on 21 December 2018 by Biomass Optimum Fuels Limited (“BOFL”) and Biomass Premium Fuels Limited (“BPFL”), respectively. In addition to the manufacturing assets, each of these companies is the owner of renewable energy equipment entitling them to receive payments pursuant to OFGEM’s Renewable Heat Initiative (“RHI”) schemes. The Investment Adviser is working closely with both companies to improve and operate the manufacturing parts of the businesses, and to monetize the RHI cash flow stream. As previously reported in the market, BOFL entered into a multiyear operating agreement with a renewable energy specialist firm. Separately, BPFL is continuing to engage with potential partners to manage or operate its manufacturing facility. As of 30 June 2019, the Company held an IFRS 9 expected credit loss reserve of £1.8 million and £1.4 million, in respect of BOFL and BPFL respectively, both of which are considered stage 2 category assets under IFRS 9. The final outcomes of this remediation remain subject to several factors outside of the Company’s control the results of which will determine the Company’s ultimate return.
In March 2019, Dawnus Construction Holdings Limited (“Dawnus”) entered administration. At the time, the Company had exposure of £2.7 million to Dawnus, secured by construction equipment. The Investment Adviser’s risk management team worked with the administrator to secure the assets, most of which were subsequently included in an auction of the borrower’s equipment. As of 30 September 2019, the Company has recovered 95% its investment and, pending certain insurance and other claims, expects to recover approximately 100% of its exposure. At the time of the insolvency, the Company established an IFRS 9 expected loss reserve of £0.4 million and considered this an IFRS 9 stage 3 category asset. This reserve was subsequently reduced as recoveries took place. As of 30 June 2019, the reserve was £0.1 million, which is anticipated to reduce as further expected recoveries are received.
In May 2019, the Company announced that one of its borrowers had experienced significant cash flow shortfalls, as all of its projects were experiencing concurrent delays. The Investment Adviser downgraded that investment in line with an IFRS 9 stage 2 asset and consequently the IFRS 9 expected loss reserve increased by £1.1 million to a total of £1.3 million in respect of this investment of £13.0 million. This renewable energy engineering company has had over 20 years of profitable operations, owns extensive patents, and has received numerous awards. In 2019, it experienced its first operating loss. The company has embarked on an equity raising program and has retained a well-known investment bank to lead the fund raising. The Investment Adviser is working closely with the borrower to help facilitate a successful capital raise. The ultimate outcome of the capital raise remains subject to a number of factors outside of the Company’s control, the results of which will determine the Company’s final return.”
Investment manager’s commentary on IFRS 9
“The Company has a disciplined risk management and surveillance process which is connected to the risk grading applied by the Investment Adviser. The allocation of expected loss reserves, in accordance with IFRS 9, is based on these credit grades. An expected credit loss reserve is established at the time each investment is made based on its credit grade and related statistical probability of loss. Investments are monitored on a regular basis and if, whether as a result of regular monitoring or as a result of some event or action, credit deterioration is observed, the investment will be reviewed for possible downgrade. If an investment is downgraded, it will attract a higher level of expected loss reserve because the risk of loss on that investment has increased.
Expected loss reserves are distinguished from case loss reserves based on the expectation of a loss. A case loss reserve is established when a loss is both probable and the amount is known. If a case loss is established for an investment, there may be no increase in loss reserves for that investment if the actual loss anticipated is not greater than the expected loss reserve then associated with that investment.
As of 30 June 2019, the aggregate amount of the Company’s IFRS 9 reserves in respect of its portfolio was £5.2 million. The Company currently has no case loss reserves because the Investment Adviser continues to believe that it will be able to recover substantially all of the value from the investments currently undergoing remediation. These investments, as with the rest of the portfolio, give rise to IFRS 9 expected credit loss reserves which would expect to reverse upon repayment or recovery in full.”
Investment manager’s commentary on the macroeconomic outlook
“The Brexit related continuing political and economic uncertainty is having an impact on the broader economy. Recent economic news has consistently trended negative, including manufacturing, employment, property prices, construction, and business activity in the City. This suggests that the UK is more likely to experience a recession. A no deal Brexit, which was previously considered unlikely, is now considered a distinct possibility. The Bank of England has noted that the consequences of a no deal Brexit could be quite adverse. Regardless of the eventual relationship between the UK and the EU, the UK economy is expected to weaken. The Investment Adviser considers that all of its existing investments are exposed to a general economic downturn.
There is a range of possible impacts on individual investments from the different Brexit scenarios and the pace of any related economic change. On balance, most of the Company’s investments are more likely to suffer from a general macroeconomic slowdown than through a direct link to Brexit, although weaker Sterling would cushion the macroeconomic impact to some degree.
Overall, the Investment Adviser remains generally concerned about the macroeconomic situation and the risks of concurrent rising inflation, falling Sterling and a slowing economy. The global picture of increased trade tensions contributes to this negative outlook. From a risk perspective, continued vigilance is required. Each investment is considered in light of its exposure to the overall economy, Sterling and related risk factors.
The Investment Adviser continues to seek to build a portfolio that is well diversified across many attributes, including diversification by borrower industry, collateral type, security structure, and amortization profile. The Investment Adviser provides a summary of selected investments on its website to provide additional information to shareholders and others.”