Pennantpark Floating Rate Capital - Earnings Call - Q2 2020

Transcript

Speaker 0

Good morning, and welcome to the PennantPark Floating Rate Capital Second Fiscal Quarter twenty twenty Earnings. Today's conference is being recorded. At this time, all participants have been placed in a listen only mode. The call will be opened for a question and answer session following the speakers' remarks. It is now my pleasure to turn the call over to Mr.

Art Penn, Chairman and Chief Executive Officer of PennantPark Floating Rate Capital. Mr. Penn, you may begin your conference.

Speaker 1

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Second Fiscal Quarter twenty twenty Earnings Conference Call. Joined today by Aviv Efrat, our Chief Financial Officer. Yves, please start off by disclosing some general conference call information and include a discussion about forward looking statements. Thank you, Art.

I'd like

Speaker 2

to remind everyone that today's call is being recorded. Please note that this call is the property of PennantPark Floating Rate Capital and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release as well as on our website. I'd also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward looking information. Today's conference call may also include forward looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections.

We do not undertake to update our forward looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at pennantparty.com or call us at (212) 905-1000. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Speaker 1

Thanks, Aviv. First, we hope that you, your families and those you work with are staying healthy and navigating through these challenging conditions. We are pleased to report that PennantPark continues to operate smoothly and effectively and remains committed to working diligently on behalf of our investors. I'm going to spend a few minutes discussing our portfolio going into the COVID-nineteen crisis, how we fared in the quarter ended March 31, how the portfolio is positioned in the upcoming quarters, our capital structure and liquidity and the value proposition of our stock, the financials and then open up for Q and A. We believe that our rigorous underwriting process and disciplined approach has successfully positioned us to manage through the challenges ahead.

We have an excellent team of talented and dedicated professionals, many with decades of experience managing through multiple economic cycles to help ensure the best possible outcome in this type of difficult environment. Although we never predicted a global pandemic, as you may know, we've been preparing for an eventual recession for some time. Prior to the COVID-nineteen crisis, we proactively positioned the portfolio as defensively as possible. Since inception, we've had a portfolio that was among the lowest risk in the direct lending industry as proven by a portfolio that has had among the lowest yields in the industry. As of March of the portfolio was in first lien senior secured debt with an weighted average yield of 7.8%.

The portfolio is constructed to withstand market and economic volatility. As of March 31, average debt to EBITDA in the portfolio was 4.2 times. The average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 2.7 times. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry.

Our focus has been on traditional middle market companies where we have benefited from terms, covenants and structures much more attractive to lenders than those of larger companies. These terms enable us to see potential challenges in portfolio companies and be positioned to assist and protect our capital much sooner than the low to no covenant loans, which are typical of larger borrowers. We have largely avoided some of the sectors that have been hurt the most by the pandemic, such as retail, restaurants, apparel and airlines. PFLP also has no exposure to oil and gas. The portfolio is extremely diversified with 108 companies and 43 different industries.

As of March 31, we had only two non accruals, representing only 0.6% of the portfolio at cost and 0% market value of the portfolio. On average, our assets were marked down approximately 5.6% in the quarter, reflecting primarily softening market conditions due to COVID-nineteen, not underlying portfolio performance. We believe this valuation as of March 31, during a time of extreme volatility, reflects that point in time and is not necessarily indicative of a long term impairment of the portfolio. Our growing team and capital resources have put us in a position to be both active and selective, whereby we only invested in approximately 4% of the opportunities that we were showing over the past year. Our credit quality since inception nine years ago has been excellent.

Out of three eighty companies in which we have invested since inception, we have only experienced nine non accruals. Since inception, PFLT has invested over $3,700,000,000 at an average yield of 8%. This compares to an annualized realized loss ratio of only seven basis points annually. If we include both realized and unrealized losses, including the unrealized losses through March 31, the annualized loss ratio is only 30 basis points annually. From an experience standpoint, we're one of the few middle market direct lenders who was in business prior to the global financial crisis and have a strong underwriting track record during that time.

Although PFLT was not in existence back then, PennantPark as an organization was and at that time was focused primarily on investing in subordinated and mezzanine debt. Prior to the onset of the global financial crisis in September 2008, we initiated investments which ultimately aggregated $480,000,000 again primarily in subordinated debt. During that recession, the weighted average EBITDA of those underlying portfolio companies declined by 7.2% at the trough of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of down 42%. As a result, the IRR of those underlying investments was 8% even though they were made prior to the financial crisis and recession.

We are proud of this downside case track record on primarily subordinated debt. Now let's turn to the outlook ahead in the coming quarters and how our portfolio is positioned. We've been communicating on a constant basis with management teams and the private equity sponsor owners of our portfolio companies. As mentioned previously, we are gratified that our historical investment focus has protected us from some of the worst hit areas of the economy such as retail, restaurants, hospitality, apparel, airlines and energy. And we've been pleased with the way our portfolio companies have moved to rapidly adjust costs and are focused on shoring up liquidity.

As of March 31, all of the companies in the portfolio paid their principal and interest in full, although two asked for and received an amendment to pay a portion of their interest in kind. Looking forward to the quarter ended June 30 and beyond, there remains meaningful uncertainty about the timing and pace of reopening the economy and its impact on the portfolio. Nevertheless, where things stand today, our analysis suggests that the vast majority of the companies in our portfolio have significant and sufficient liquidity to pay their interest payments as they come due in the coming quarters. Having said that, we expect that certain portfolio companies will ask for amendments allowing temporary covenant relief given the substantive impact of the shutdown on their operating performance. We are comforted that most of the loans in our portfolio benefit from real covenants which step down.

These covenants may require some amendments in the current environment, but they allow us to monitor the portfolio closely and to ensure companies are taking appropriate actions to protect our investment. There are some companies in our portfolio that have seen significant drops in revenue due to COVID, such as companies in the gaming industry. Gaming represented only 5.4% of the portfolio as of March 31 across seven investments. Our largest gaming investment last quarter was substantially refinanced. The remaining residual loan is to a wholly owned subsidiary of a large investment grade company with a full interest reserve until early twenty twenty one.

Two of the other gaming companies are undertaking construction phase projects, which provide them with interest reserves into mid-twenty twenty one. The other four properties are regional facilities. Its primary customer base does not need to get on a plane. Those properties were experiencing record performance prior to the shutdown, and owners of those facilities have aggressively cut costs. While we do not know when the properties will reopen, I'll have cash on the balance sheet that will allow cushion to reopen in the third or fourth quarter, and we expect strong performance once these properties reopen.

On the positive side, many of our portfolio companies are in businesses such as government services, defense contracting, software, communications and cybersecurity, which collectively comprise a substantial portion of our portfolio and should be less impacted by COVID. With regard to our financials, I'll give some summary highlights, and then Pete will go into more detail. Our net investment income was $0.30 per share, which exceeded our dividend of $0.285 per share. Based on the earnings stream, at this point in time, we do not intend to adjust the dividend. Of course, we will continue to evaluate our earnings stream over time relative to the dividend.

Our GAAP debt to equity ratio was 1.57x, while GAAP net debt to equity after subtracting cash was 1.5x. Regulatory debt to equity ratio was 1.81x, and our regulatory net debt to equity ratio after subtracting cash was 1.74x. As many of you know, in early two thousand and nine, in response to the global financial crisis, we started marking many of our liabilities, our credit facilities and bonds to market to better align asset and liability values. This reduces the volatility of NAV in times of market volatility such as we have today. The additional benefit at the time and for the ensuing decade was that it reduced the volatility of our leverage as calculated for the regulatory asset coverage test.

About nine months ago, the SEC guided us that for the regulatory asset coverage purposes, they will prefer we mark liabilities at cost, not marketing, which we now do for that test. As a result, we will be highlighting both GAAP leverage and regulatory asset coverage leverage in times such as these when there is a material difference. With regard to NAV, our GAAP NAV was $12.12 per share as of March 31, down approximately 6% from the prior quarter, which reflects both the markdown of assets and certain liabilities. Spending liabilities were not mark to market, adjusted NAV would have been $11.1 down approximately 13% from the prior quarter. With regard to leverage, we've been targeting a debt to equity ratio of 1.4 to 1.7 times.

Our net of cash regulatory asset coverage ratio of 1.74 times was at the upper end of our range this past quarter. This was primarily due to a 5.6% decrease in the mark to market of our portfolio as well as more active drawing of revolvers by our borrowers. We have ample liquidity of funded revolver draws and we're in compliance with all of our facilities at March 31. As of today, we have liquidity to support our commitments. We are looking to carefully manage our leverage over time, and we expect to stay in compliance with both regulatory requirements and covenants under our credit facilities.

We have a strong capital structure with diversified funding sources and no near term maturities. We have $520,000,000 of revolving credit facility maturing in 2023 with the syndicate of 11 banks, $413,000,000 drawn as of March 31, dollars 139,000,000 of unsecured senior notes maturing in 2023 and $228,000,000 of asset backed debt associated with PennantPark CLO through 02/1931. We've been in consistent dialogue with our lenders and are thankful for their support. We are primarily focused on our existing portfolio. We will selectively make new investments, although the bar is currently high.

Our focus continues to be on companies with structures that are more defensive, have reasonable leverage, covenant protections and attractive returns. With regard to our stock price, we believe that the share price of PFLT does not accurately reflect the long term value of the company. As we stated earlier, the average debt to EBITDA of our underlying portfolio as of March 31 was 4.2x. We're employing this into the language of value investors. At the stock price of PFLT today, well below NAV, we, the shareholders, own a portfolio of companies at a multiple of about 2.6x cash flow.

Even in a recession, with potential declines in cash flow, value investors should be able to appreciate at attractive low multiple. As previously disclosed, directors, officers and employees of Benebarc Investment Advisors purchased about 535,000 shares of PFLP in February and March because we thought it was an excellent investment opportunity and to demonstrate strong alignment of interest with our shareholders. Let me now turn the call over to Aviv, our CFO, to take us through the financial results in more detail.

Speaker 2

Thank you, Mark. For the quarter ended March 31, net investment income was $0.30 per share. Looking at some of the expense categories, management fees totaled about $5,900,000 Taxes, general and administrative expenses totaled about $1,000,000 and interest expense totaled about $7,600,000 During the quarter ended March 31, net unrealized depreciation on investment was about 65,000,000 or 167¢ per share. Net realized losses was about $1,600,000 or $04 per share. Net unrealized appreciation of our credit facility and notes was $0.86 per share.

Net investment income exceeded the dividend by $02 per share. Consequently, NAV went from $12.95 to $12.12 per share. Adjusted NAV, excluding the mark to market of our liabilities, was $11.1 per share. The decline in NAV was primarily due to a 5.6% average valuation decline on the investment portfolio combined with increased leverage. Our entire portfolio, our credit facility and notes are mark to market by our board of directors each quarter using the equity price provided by an independent valuation firm, exchanges or independent broker dealer quotes when active markets are available under ASC eight twenty and eight twenty five.

In cases where a broker dealer quotes are inactive, we use independent valuation firms to value the investments. Our portfolio remains highly diversified with 108 companies across 43 different industries. 91% is invested in first lien senior secured debt, including 10% in PSFL, 3% in second lien debt and 6% in equity, including 4% in PSFL. Our overall debt portfolio has a weighted average yield of 7.8%. 99% of the portfolio is floating rate and about 90% of the portfolio has a LIBOR floor.

The average LIBOR floor is 1%. Now let me turn the call back to Hart.

Speaker 1

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is a steady, stable and protected dividend stream coupled with the preservation of capital. Everything we do is aligned to that goal, and we try to find less risky middle market companies that have high free cash flow conversion, capture that free cash flow primarily in first lien senior secured instruments. We pay out those contractual cash flows and fund the dividends to our shareholders.

In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your investment and confidence in us. That concludes our remarks. At this time, I'd like to open up the call to questions.

Speaker 0

Thank And we'll go first to Mickey Schallien of Ladenburg.

Speaker 2

Good morning, everyone. Art, just in terms of risk assessment, and I'm sorry if you mentioned it in the prepared remarks, but can you give us a sense of what the portfolio's average EBITDA is at this point?

Speaker 1

Average EBITDA is Mickey, can you hear me?

Speaker 2

Yes.

Speaker 1

Okay. Average EBITDA is roughly 35,000,000 to $40,000,000 on average in terms of the average So

Speaker 2

in the middle market level. And what trends did you see in the first quarter?

Speaker 1

Look, we had a very strong first calendar quarter, we had a very strong quarter up until the March. So we saw very strong performance across the portfolio going into the COVID-nineteen crisis.

Speaker 2

Okay. And in terms of sponsors, how would you characterize their behavior in April and in May in terms of helping support liquidity of the portfolio companies?

Speaker 1

Yes. We've seen very, by and large, good behavior and actions from the sponsors, both in doing what it takes in terms of reducing expenses, in terms of shoring up liquidity and managing their liquidity. In many cases, they have cut off their fees that they're earning from these companies. So by and large, that's one of the benefits you see from kind of a sponsor portfolio with embedded equity from the sponsors underneath of us. There's certainly a strong alignment of interest.

Going into this. The average loan to value was about 50%. So there's a lot of equity beneath us, a lot of support, and the actions that we've seen are have been helpful.

Speaker 2

Okay. My last question. Art, can you remind me what the target debt to equity is for PFLT in a normal market?

Speaker 1

Yes. So in a normal market, we've been saying 1.4 times to 1.7 times. So here we are at the upper end of that due to both the mark to market as well as the drawing on the revolvers from many of the underlying portfolio companies. So we're managing that leverage carefully. There's been some sell downs at nice prices post quarter end to create additional liquidity, additional cushion.

And because so much of our portfolio is away from the COVID-nineteen risk, It's an we have a bunch of attractive deals. They're both attractive for us as well as for certain other parties. We haven't had a problem finding some nice levels post quarter end to the extent we want to create more cushion and more liquidity in the system.

Speaker 3

My first one just has to do with your asset backed notes. As you kind of evolve through this process, I think we've seen that the asset backed notes or security rates or CLOs for different BDCs can be seen in most concerning liability conscious because they're not as flexible. They don't work with a banking partner. They could come in there and amend them and work with the borrower. So can you just talk about your comfort level surrounding the current covenants, whether it's the CCC bucket or the OC test or any other covenants that you guys feel in those asset backed notes?

Speaker 1

Yes. Thanks, Ryan. That's an excellent question. So with our CLO, we have a 17.5% CCC bucket. And we have plenty of cushion now against that.

It's something that we're watching and we we manage, but there's no no issues in the no issues that we see happening with that. The other thing I'll note is that with our securitization, in addition to retaining the equity, we also retained the BBB tranche. So it's a less levered. In essence, it's a less levered CLO to begin with.

Speaker 3

Okay. And then what about the credit facility that you guys have in the PSSL? Can you talk about your comfort around that? Obviously, that has a little bit that's high leverage as well. Can you talk about your guys' comfort with the ability to not trip any covenants from that?

Speaker 1

Yes. So we have a in our joint venture, PSSL, we have that's, again, a joint to refresh everyone's memory. That's a joint venture we have with Kemper. The bank there is Capital One and syndicate of other banks. We've been having great conversations with Capital One, kind of very transparently sharing with them what's going on in the portfolio.

And those conversations are ongoing, but we feel very good about the context of that dialogue and relationships. And I think just to kind of take it to a bigger level, I think the banking regulators in The United States, the Fed, the SEC, the control over the currency have been very clear with the people that regulate that COVID-nineteen risks in portfolios that the bank should be very should have soft hands, should be working with borrowers and should be giving people room. And certainly, as we've been having conversations with all of our banks across the PennantPark platform, we've seen very excellent behavior backed up by many years of long term partnership that we've had with them. So good open dialogue. Certainly, COVID-nineteen is having a significant impact on the economy, and our banks seem to understand that.

Speaker 3

Okay. And then I know you guys touched on this earlier and provided some comments around the gaming industry, talked about four of your properties are regionally going to

Speaker 2

have to get on a plane. A couple of

Speaker 3

them are under some construction, one was slowed down and kind of folded into a higher quality investment grade company. But just can you talk about kind of how those businesses operate? Obviously, I would assume that they're all shut down right now producing zero revenues. What is the ability and how can those companies run during a downturn like this as far as cutting costs, increasing the one way to conserve cash for the longer term? And and then lastly, just, you know, what what idea is kind of the ultimate outlook of those businesses in in your mind right now?

Obviously, it's gonna be largely dependent on when the economy opens, but I would think that some

Speaker 2

of those businesses may be some

Speaker 3

of the last ones to be able to reopen just because it's crowded places that aren't really essential. So just any additional commentary would be helpful on that.

Speaker 1

Sure. So look, I think you hit on all the right points, which are if you're one of those companies, you really cut all your costs to the absolute minimum, fixed cost, skeletal staff, unfortunately, means your variable costs, such as your employees, you know, furloughed or laid off. And you are maximizing your liquidity in every way you can maximize in your liquidity and creating several quarters of runway of being shut down. And by and large, most of them, you know, have done that. They they have harbored their liquidity well.

They have, you know, kinda cut their ongoing cost to to the bare minimum. And based on what we can see, they've got plenty of runway to to to deal with a gradual reopening of the time, and even when there is a reopening, a gradual a gradual increase in traffic. So so we think they've they've done a they've done a good job. And certainly, since the vast majority of them are regional facilities where, you know, because if the customers are local, they don't need to get on a plane, you We think they're as well set up as anybody to deal with a prolonged downturn. So the playbook is there.

They've operated the playbook. Now we just need to kind of see how things go.

Speaker 3

And

Speaker 0

now we will go to David Miyazaki of Confluence Investment Management.

Speaker 1

Sorry about that.

Speaker 2

Art, just a question for you. I think way back when you guys elected to mark your liabilities to market, we had some some real good conversations around that. I think one of the central points you made was that it better aligns the movement of the asset side of the balance sheet with the liability side of the of the balance sheet. I think that was something that, you know, my recollection is that it's very helpful for PMMT during the financial crisis of the way. So I was wondering if you could share with us some of the maybe details of what the SEC said when they expressed some preference for a cost based mark on your liabilities.

I presume that you made the point to them that this was a better alignment of both sides of the balance sheet. So what was sort of the nature of that conversation?

Speaker 1

Yeah. I'm I'm laughing because, you know, you know, these are very quiet conversations and, you know, just suffice to say that, you know, you know, we we really liked the marketing liabilities to market for a lot of reasons, including the reduction of volatility. And also, you know, for SEC asset coverage purposes, to the extent you can use it, it's a terrific insurance policy. It's and it really really could be a solution for the broader industry in times of volatility like we're having today. But nine months ago, of course, after using it for decades, the SEC guided us that for the SEC regulatory asset coverage ratio, they would prefer that we do not use it going forward.

So we are not for the regulatory asset test. Certainly, it's already part of our GAAP financial statements. And you know, the the way it works is every time you you take down a liability, whether it be a credit facility or a bond, you have a onetime option to to mark that liability to mark it under GAAP. So so that's what we have been doing until recently, using that option under GAAP. And, you know, until recently, GAAP and regulatory asset coverage are virtually the same because you have very calm markets.

So here we are in a volatile market as of threethirty one. And for GAAP purposes, we marked many of our liabilities to market, which does the volatility of NAV but does not get taken into account for the regulatory

Speaker 3

asset coverage test, which is kind

Speaker 1

of why we're now you see it on the press release why we now do regulatory as well as GAAP debt to equity. And we do also show an adjusted NAV per share, which takes out the mark to market of the liability. So it makes it complex. I apologize to everybody. It was done with the best of intentions of reducing the risk of our vehicles when we did it.

Today, it just makes it more complex from the standpoint of our financials. But we do think there is an underlying logic, as I said, of building it. In terms of the SEC dialogue, I do not have the dialogue. It was our attorneys who have the dialogue with the SEC. And our attitude is when the SEC guides us

Speaker 2

to do something, we should we should

Speaker 1

be listening to that. So so we are we are listening to their guidance, and and we still are in fine shape as you've seen. We'd be in better shape in some sense if we get under the old regime, but it is what it is, and we will live under the constraints that were given at this point in time.

Speaker 2

I I appreciate that. I know that it's it's really a a multidimensional sort of the data. So whether or not that that's the best disclosures to market or not. But certainly, I think that may not have two different cycles of of extreme market, illiquidity to show that this can help dampen some of the, the the big swings that took took place in least for for BDC's and then that asset value. So I I guess I was just a little surprised to see that there wasn't a little bit of recognition that there's some detail that you really had in that that that accounting interpretation.

So thank you for your comments there. The other question I had was, you've mentioned, I think you said that you just make sure that you deal flow and that you have a lot of different opportunities to put capital to work right now that are that looks pretty attractive. And and that's a little bit in contrast to what we've heard from some BDCs that lend. And I guess that it would be called the upper middle market, not the the 35 to $40,000,000 EBITDA. They're they're probably more in the, call it, 75 to a $100,000,000 neighborhood where I think the the comment somebody said that nothing is happening.

That lenders and borrowers today can't even agree on what day of the week it is. So your your comment in on the 35 to 40,000,000, is is that something that is if the market gets lower in the middle market, that there's more deal flow taking place right now?

Speaker 1

Just just to clarify. I said that yeah. I said I don't know. I think this is part of my my remarks. There there really is not a lot of deal flow at this point in time in the primary, you know.

So there's not a lot of primary deal flow. Certainly, in some of the areas that are completely unimpacted, as we've seen in certain defense contractors, government services, there's a little bit of deal flow. And it's in part because that sector never really that's kind of motoring along. That's a reasonable chunk of portfolio. And there still are private equity sponsors trying to get deals done, but it's not like there's been a lot of deals, you know, done in that space.

So there's not a lot going on, in the market, but buyers and sellers of of companies as well as, lenders are trying to figure out where risk adjusted returns should be for non COVID impacted companies. And to the extent, there is activity, some activity, it's in that space. So it really isn't a lot new. There is some secondary opportunities that we think could be attractive. For PFLT, I think our mission today is really to focus on the portfolio.

We will selectively or we'll look to selectively make investments that are new, but the bar is high at this point. I think we've just got to kind of focus on our portfolio and kind of make sure we have focus on those portfolio companies first.

Speaker 2

Okay. Thank you for the clarification.

Speaker 1

I'm sorry I got that wrong.

Speaker 0

And with that, I'd like to turn the call back to Art for any additional or closing comments.

Speaker 1

Thank you, everybody, for listening in today. We appreciate it. We wish everyone safety and health in these times, and we look forward to speaking with you next in August, which will be our next quarter. Thank you very much.

Speaker 0

With that, ladies and gentlemen, that does conclude today's call. We'd like to thank you again for your participation. You may now disconnect.