Heritage Insurance Holdings, Inc. Debt Disclosure

Senior Secured Notes

On December 15, 2016, we issued $79.5 million aggregate amounts of Senior Secured Notes (“Secured Notes”) to six accredited investors. The Secured Notes bear interest of 8.75% per annum plus the three-month average of LIBOR. Principal and interest is paid quarterly. Interest payments commenced on March 15, 2017 and the quarterly principal payments commence on December 31, 2018. At December 31, 2017, we owed $73.7 million on the Secured Notes, net of issuance costs which totaled approximately $5.7 million. For the year ended December 31, 2017, the Company made interest payments of approximately $8.0 million.

The Secured Notes contain customary restrictive covenants relating to merger, modification of the indenture, subordination, issuance of debt securities and sale of assets, the most significant of which include limitations with respect to certain designated subsidiaries on the incurrence of additional indebtedness or guarantees secured by any security interest on any shares of their capital stock. The Secured Notes covenants also limit the Company’s ability to sell or otherwise dispose of any shares of capital stock of such designated subsidiaries. The Secured Notes do not have the benefit of any sinking funds. They also contain customary limitations and lien provisions as well as customary events of default provisions, which if breached, could result in the accelerated maturity of the Secured Notes. The Company was in compliance with the Senior Notes covenants for the year ended December 31, 2017.

Subject to the replacement capital covenant, the Secured Notes may be redeemed, in whole or in part, at any time on or after December 15, 2018, based on the quarterly payment date, at the following redemption prices (as a percentage of outstanding principal amount of the notes to be redeemed) plus accrued and unpaid interest and principal: 2018 – 103%; 2019 – 102%; 2020 – 101%; and thereafter at 100%. If there is a change in control, a holder has the right to require the Company to purchase such holder’s Secured Notes at a price in cash equal to 101% of the principal amount thereof, plus accrued and unpaid interest, if any.

At December 31, 2017, the effective interest rate, considering the stated interest expense and amortization of debt issuance costs, approximates 10%.

Convertible Senior Notes

On August 16, 2017, the Company issued $125.0 million aggregate principal amount of 5.875% Convertible Senior Notes due 2037 (the “Convertible Notes”) under an Indenture (the “Indenture”) by and among the Company, as issuer, Heritage MGA, LLC, as guarantor, and a third-party trustee (the “Trustee”). The Convertible Notes were issued in a private placement transaction pursuant to Rule 144A under the Securities Act, as amended. On September 7, 2017, the Company issued an additional $11.75 million in aggregate principal amounts of Convertible Notes pursuant to the initial purchaser’s option.

The Convertible Notes bear interest at a rate of 5.875% per year. Interest accrues from August 16, 2017 and will be payable semi-annually in arrears, on February 1 and August 1 of each year, beginning on February 1, 2018. The Convertible Notes are senior unsecured obligations of the Company that will rank senior in right of payment to the Company’s future indebtedness that is expressly subordinated in right of payment to the Convertible Notes; equal in right of payment to the Company’s unsecured indebtedness that is not so subordinated; effectively junior to any of the Company’s secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness or other liabilities incurred by the Company’s subsidiaries other than the Guarantor, which will fully and unconditionally guarantee the Convertible Notes on a senior unsecured basis.

The Convertible Notes will mature on August 1, 2037 (the “Maturity Date”), unless earlier repurchased, redeemed or converted.

Holders may convert their Convertible Notes at any time prior to the close of business on the business day immediately preceding February 1, 2037, other than during the period from, and including, February 1, 2022 to the close of business on the second business day immediately preceding August 5, 2022, only under the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on September 30, 2017, if the closing sale price of the Company’s common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the calendar quarter immediately preceding the calendar quarter in which the conversion occurs, is more than 130% of the conversion price of the Convertible Notes in effect on each applicable trading day; (2) during the ten consecutive business-day period following any five consecutive trading-day period in which the trading price for the Convertible Notes for each such trading day was less than 98% of the closing sale price of the Company’s common stock on such date multiplied by the then-current conversion rate; (3) if the Company calls any or all of the Convertible Notes for redemption, at any time prior to the close of business on the second business day immediately preceding the redemption date; or (4) upon the occurrence of specified corporate events.

Upon the occurrence of a fundamental change (as defined in the Indenture) (but not, at the Company’s election, a public acquirer change of control (as defined in the Indenture)), holders of the Convertible Notes may require the Company to repurchase for cash all or a portion of their Convertible Notes at a fundamental change repurchase price equal to 100% of the principal amount of the Convertible Notes to be repurchased, plus accrued and unpaid interest to, but excluding, the fundamental change repurchase date .

Except as described below, the Company may not redeem the Convertible Notes prior to August 5, 2022. If the NBIC Acquisition had not been consummated for any reason by June 8, 2018, or if the acquisition agreement relating to the NBIC Acquisition had terminated for any reason (other than by consummation of the NBIC Acquisition), the Company could redeem all, but not less than all, of the outstanding Convertible Notes for cash on a redemption date to occur on or prior to August 31, 2018 for a redemption price for each $1,000 principal amount of Convertible Notes equal to the sum of (i) $1,010, (ii) accrued and unpaid interest on such Convertible Notes to, but excluding, the redemption date and (iii) 75% of the excess, if any, of the redemption conversion value (as defined in the Indenture) over the initial conversion value (as defined in the Indenture). On or after August 5, 2022 but prior to February 1, 2037, the Company may redeem for cash all or any portion of the Convertible Notes, at the Company’s option, at a redemption price equal to 100% of the principal amount of the Convertible Notes to be redeemed, plus accrued and unpaid interest to, but excluding, the redemption date. No sinking fund is provided for the Convertible Notes, which means that the Company is not required to redeem or retire the Convertible Notes periodically. Holders of the Convertible Notes will be able to cause the Company to repurchase their Convertible Notes for cash on any of August 1, 2022, August 1, 2027 and August 1, 2032, in each case at 100% of their principal amount, plus accrued and unpaid interest to, but excluding, the relevant repurchase date.

The Indenture contains customary terms and covenants and events of default. If an Event of Default (as defined in the Indenture) occurs and is continuing, the Trustee by notice to the Company, or the holders of at least 25% in aggregate principal amount of the Convertible Notes then outstanding by notice to the Company and the Trustee, may declare 100% of the principal of, and accrued and unpaid interest, if any, on, all the Convertible Notes to be immediately due and payable. In the case of certain events of bankruptcy, insolvency or reorganization (as set forth in the Indenture) with respect to the Company, 100% of the principal of, and accrued and unpaid interest, if any, on, the Convertible Notes will automatically become immediately due and payable.

 

The trading price of the underlying Secured Note as of December 31, 2017 was approximately 1.07 of par value. Debt issuance costs are capitalized and presented as a deduction from the carrying value of the debt. The debt discount and issuance costs are amortized to interest expense over the expected life of the underlying debt of 5 years. As there are offsetting puts and calls on the debt security in August 2022 at par, it will be economically beneficial for one party, either the company or the noteholders to exercise their option.

The Company records the fair value of these derivatives on its balance sheet at fair value with changes in the values of these derivatives reflected in the consolidated statement of operations. The embedded derivatives are valued using the Convertible Lattice model at issuance and at the end of each quarter and marked to fair value with corresponding adjustment as “gain or loss” on change in fair values included in Other Non-Operating expense in the consolidated statements of operations.

On December 1, 2017, the Company held a Special Meeting of Stockholders, at which the Company’s stockholders approved, as required by Rule 312 of the New York Stock Exchange Listed Company Manual, the issuance of the Company’s common stock upon conversion of the Convertible Notes. Pursuant to the approval, the Company has the ability to settle the conversion option in shares of common stock, cash or a combination thereof. Upon conversion of the Convertible Notes, the Company intends to pay cash in respect of only the principal amount of the Convertible Notes being converted or (if lower) the conversion value thereof, and to settle any amounts in excess thereof in cash, shares of common stock or a combination thereof, at the Company’s election.

Prior to receipt of stockholder’s approval, the Company recorded the fair value of the derivatives liability on its balance sheet at fair value with changes in the fair values reflected in the consolidated state of operations. Beginning December 1, 2017, the conversion option of the Convertible Notes qualifies for equity classification and will no longer be accounted for as a separate derivative instruments liability in accordance with applicable U.S. GAAP guidance. The Company valued the embedded derivative and recorded additional paid-in-capital of $51.6 million. In connection with the change in fair value, the Company recognized a fair value change for the year ended December 31, 2017 of $41.0 million as non-operating expense in the statement of operations.

The valuation of the embedded derivatives within the convertible note was completed with the following assumptions:

 

 

The following table summarizes the derivative liability activity for the year ended December 31, 2017:

 

 

Debt Extinguishment

Between October 2, 2017 and November 14, 2017, the Company, through its subsidiary Heritage P&C, reacquired $21.1 million of its outstanding Convertible Notes in the open market at a premium for $25.2 million. In accordance with purchase agreement governing the Company’s offer and sale of the convertible debt, the Company or its affiliates are prohibited from reselling the notes once acquired. The repurchased Convertible Notes hold no registrations rights.

In accordance with ASC 470 “Debt”, the Company evaluated the accounting treatment to determine if the repurchase of the Convertible Notes by its subsidiary constituted a debt extinguishment. ASC 405-20-40-1 provides implementation guidance in order to determine if the Company is legally released from being the primary obligor under the liability, either judicially or by the creditor.

Based on the reacquisition of the Convertible Notes by the Company, through Heritage P&C, the Company should derecognize the related debt and conversion option liability.

Upon extinguishment, the Company performed a discounted cash flow (“DCF”) analysis for each transaction based on its date and principal amount, leveraging market debt yield data as of each trade date to estimate the cost of the debt. The Company removed the net debt of $17.7 million and liability derivative at the carrying amount in the amount of $6.2 million. The extinguishment of debt was measured at the then-current fair value at the time of purchase, with any difference recorded as a gain or loss on the extinguishment of the two separate accounting liabilities. The Company recognized a net loss of $1.2 million on extinguishment.

 Mortgage Loan

On October 30, 2017, the Company and its subsidiary, Skye Lane Properties LLC (“Skye Lane”), jointly obtained a commercial real estate mortgage loan in the amount of $12.7 million which is secured by a first mortgage on the real property owned by Skye Lane. The term of the loan shall end on October 30, 2027. The loan shall bear interest at an initial interest rate equal to 4.95% per annum. On October 30, 2022, the interest rate shall adjust to an interest rate equal to the annualized interest rate of United States 5-year Treasury Notes as reported by the Federal Reserve on a weekly average basis plus 3.10%. The loan is payable monthly of principal and interest based upon a 25-year amortization. As of December 31, 2017, the Company paid $54,000 for interest expense and $43,000 for principal.

The following table summarizes the Company’s long-term debt (in thousands):

 

Expected annual principal payments due by the Company under the long-term debt agreements is as follows: