Pennantpark Floating Rate Capital - Q2 2024

Transcript

Operator (participant)

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.

Art Penn (Chairman and CEO)

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's second fiscal quarter 2024 earnings conference call. I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Rick Allorto (CFO)

Thank you, Art. I'd like 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. An audio replay of the call will be available 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 pennantpark.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.

Art Penn (Chairman and CEO)

Thanks, Rick. We're going to spend a few minutes discussing the current market environment for middle market lending, how we fared in the quarter ended March 31st, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, and then open it up for Q&A. For the quarter ended March 31st, GAAP net investment income was $0.31 per share. GAAP NAV and adjusted NAV increased 1.8% to $11.40 per share from $11.20 per share. The increase in NAV for the quarter was due primarily to positive valuation adjustments on both debt and equity investments. As of March 31st, our portfolio grew to $1.5 billion, or up 16% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities and invested $338 million in 11 new and 48 existing portfolio companies at a weighted average yield of 11.6%.

For the investments in new portfolio companies, the weighted average debt to EBITDA was 4.2x, the weighted average interest coverage was 2.1x, and the weighted average loan to value was 42%. On average, we have seen a 50 basis point tightening on first lien spreads over the last six months. However, we continue to believe that the current vintage of core middle market directly originated loans is excellent, and the core middle market leverage is lower, spreads and upfront OID are higher, covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market and the core middle market, we are still getting meaningful covenant protections. As of March 31st, our debt to equity ratio was 1.2 to 1.

With a target ratio of 1.5 to 1, we believe that we are well positioned to drive additional growth in net investment income going forward. Securitization financing continues to be a good match for our lower-risk first lien assets. During the quarter, PFLT closed a $351 million term debt securitization transaction with a weighted average spread of 2.79%, a four-year reinvestment period, and a 12-year final maturity. The AAA portion of the structure priced at a weighted average spread of 2.3%. The ratio of external debt to PFLT's junior capital was 4.5 to 1, which creates plenty of liquidity for the company. The proceeds were used to repay a portion of our senior secured revolving facility, which will be available to reborrow and invest in new originations as we continue to grow the PFLT portfolio.

We expect additional growth in NII, in part driven by our investment in the joint venture. As of March 31st, the JV portfolio totaled $870 million, and together with our JV partner, we continue to execute on the plan to grow the JV portfolio to approximately $1 billion of assets. During the quarter, the JV invested $80 million in six new and four existing portfolio companies at a weighted average yield of 11.6%, including $77 million of assets purchased from PFLT. We believe that the increase in scale of the JV's balance sheet will continue to drive an attractive mid-teens return on invested capital and enhance PFLT's earnings momentum. Credit quality of the portfolio has remained strong. We added one new investment to non-accrual status and removed one investment. Non-accruals represent only 0.4% of the portfolio at cost and 0.3% at market value.

For the quarter ended March 31st, PIK income remained low at only 1.7% of total investment income, which we believe is among the lowest in the BDC sector. As of March 31st, the portfolio's weighted average leverage ratio through our debt security was 4.4 times, and the portfolio's weighted average interest coverage was 2.2 times. We believe that this is one of the most conservatively structured portfolios in the direct lending industry and is a testament to our focus on the core middle market. We like being positioned for capital preservation as a senior secured first lien lender focused on the United States. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities where we provide important strategic capital to our borrowers.

We have a long-term track record of generating value by successfully financing growing middle market companies in five key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask, and have an excellent track record. There are business services, consumer, government services, and defense, healthcare, and software and technology. These sectors have also been resilient and tend to generate strong free cash flow. Approximately 19% of our portfolio is in government services and defense, which is a sector with strong tailwinds in this geopolitical environment. In our software vertical, we don't have any exposure to ARR loans. In the core middle market, which we define as companies with 10-50 million of EBITDA, that is below the threshold and does not compete with the broadly syndicated loan market or the high yield markets, unlike our peers in the upper middle market.

In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, attractive upfront OID, and equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated first lien loans have meaningful covenants which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. Many of our peers who focus on the upper middle market state that those bigger companies are less risky. That may make some intuitive sense, but the reality is different.

According to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate and a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence, and tighter monitoring have been an important part of this differentiated performance. Our credit quality since inception over 13 years ago has been excellent. PFLT has invested $5.9 billion in 492 companies, and we have experienced only 18 non-accruals. Since inception, PFLT's loss ratio on invested capital is only 12 basis points annually. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time.

Overall, for our platform, from inception through March 31st, we have invested over $469 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1x. Our experienced, intelligent team and our wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors. Our mission and goal are a steady, stable, and protected dividend stream coupled with the preservation of capital. Everything we do is aligned to that goal. We seek to find investment opportunities in growing middle market companies that have high free cash flow conversion. We capture that free cash flow primarily in first lien senior secured instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders.

Let me now turn the call over to Rick, our CFO, to take us through the financial results in more detail.

Rick Allorto (CFO)

Thank you, Art. For the quarter ended March 31st, GAAP net investment income was $0.31 per share. Operating expenses for the quarter were as follows. Interest and expenses on debt were $14.7 million. Base management and performance-based incentive fees were $8.2 million. General and administrative expenses were $1.8 million, and provision for taxes were $0.5 million. For the quarter ended March 31st, net realized and unrealized change on investments, including provision for taxes, was a gain of $12 million or $0.20 per share. As of March 31st, our GAAP NAV was $11.40, which is up 1.8% from $11.20 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.40 per share, up 1.8% from $11.20 per share last quarter.

As of March 31st, our debt to equity ratio was 1.2 times, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of March 31st, our key portfolio statistics were as follows. Our portfolio remains highly diversified with 146 companies across 44 different industries. The weighted average yield on our debt investments was 12.3%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 1.7% of total investment income. We had one non-accrual, which represents 0.4% of the portfolio at cost and 0.3% at market value. The portfolio is comprised of 87% first lien senior secured debt, less than 1% in second lien and subordinated debt, 6% in equity of PSSL, and 7% in other equity. Debt to EBITDA on the portfolio is 4.4 times, and interest coverage was 2.2 times.

Now let me turn the call back to Art. Thanks, Rick. In closing, I'd like to thank our dedicated and talented team of professionals for their continued commitment to PFLT and its shareholders. Thank you all for your time today and for your investment and confidence in us. That concludes our remarks. At this time, I would like to open up the call to questions.

Operator (participant)

Thank you. If you would like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star one to ask a question. We will take our first question from Brian McKenna from Citizens JMP. Please go ahead.

Brian McKenna (Managing Director and Senior Equity Research Analyst)

Thanks. Good morning, all. It's great to see all the growth in the investment portfolio year to date, up nearly 40% over the past 2 quarters. Leverage, as you mentioned, is still below your 1.5x target. How should we think about growth of the portfolio from here? How does all this growth ultimately impact the trajectory of NII over the next few quarters?

Rick Allorto (CFO)

Thanks, Brian. It's a good question. Look, our belief is that the back half of 2024 is going to be active. So we think we're going to be able to be very active, deploy really good capital at this good vintage with these credit statistics. So kind of we're hoping that come the turn of the year, turning into 2025, we'll kind of be pretty close at or pretty close to our target leverage.

Brian McKenna (Managing Director and Senior Equity Research Analyst)

Yep. Got it. Okay. Makes sense. And then just a follow-up. In the quarter, you invested in 11 new portfolio companies, 48 existing portfolio companies, and that was at an average weighted yield of 11.6%. So a couple of questions here. How much did average yields come in relative to the last couple of quarters for new investments? Can you give any color on quarter-to-date spreads or yields? I know you mentioned kind of tightening of 50 basis points. Has that trended differently just kind of over the last several weeks here? And then moving forward just on deployment, how should we think about the mix of new investments versus kind of existing portfolio company investments?

Rick Allorto (CFO)

Yeah. Yes. Spreads over the last 6-9 months have come in on average about 50. So what was a SOFR + 600 is kind of more like a SOFR 550 right now. We think that's kind of meeting its low. We do believe there's a shot that spreads will widen again, particularly if there's a lot of supply, if there's a lot of activity coming into the end of 2024, which we believe there will be. Given supply-demand, we think there's a shot that spreads may widen. We don't underwrite that. You shouldn't underwrite that, but that's certainly a possibility. We think at this point, they've kind of reached their minimum.

In terms of kind of new platforms versus existing, I mean, that's the nice thing about what we have is we have over 100 companies in the portfolio, most of which are companies that are growing that need additional capital. Part of the value proposition that we add to those borrowers and those private equity sponsors is that we're a strategic lender there to help them grow and to provide additional capital to fuel that growth. So that even in quarters where there's fewer activity in newer platforms for us, we still are very busy with the existing portfolio and financing the existing portfolio. I guess what you're hearing from me is that between now and your end, we believe there's going to be a greater mixture of new platform names in our portfolio as part of the mix. We like the new platform names.

New platform names are kind of part of this vintage. As you can see, it's kind of low-4s debt-to-EBITDA, very meaningful covenants, very good loan-to-value. So we're optimistic that between now and year-end, calendar year-end, we're going to be busy with this newer vintage.

Brian McKenna (Managing Director and Senior Equity Research Analyst)

All right. I'll leave it there. Thanks, Art.

Rick Allorto (CFO)

Thank you.

Operator (participant)

We will take our next question from Mark Hughes from Truist. Please go ahead.

Mark Hughes (Managing Director and Senior Equity Research Analyst)

Yeah. Thank you. Good morning. Art, your outlook for spreads potentially to widen, as you say, don't take it to the bank, but it's an idea. Is that supply and demand? Is that because you think there'll be a lot of opportunities coming to market, and that'll benefit you all, or do you think there's some additional risk that may be coming later in the year? How do you see that?

Rick Allorto (CFO)

Yeah. I mean, it's a good question. My comments were more focused on supply-demand of deal flow. So in a world where our view is that we think there's going to be a lot of deal flow in the back half of 2024, that's where that comes from. It doesn't come from any projection about the health of the economy. As you know, Mark, we underwrite our scenarios as lenders always assuming there's a soft economic environment early on in the deal. And whether there's one or not, we have no idea. No one really does. But we assume that, which is why we generally structure these loans as very conservative, low leverage, high equity cushion, good covenants, good information rights, kind of believing at some point there may be a bump. It could be sooner. And we need to structure these deals as if there's a bump sooner.

But we don't have any prognostication about that.

Mark Hughes (Managing Director and Senior Equity Research Analyst)

Understood. And then the positive valuation marks in the quarter helped drive up NAV. Any detail you can provide? Was that equity performance, just broader capital market movements influencing that? Would be curious if any kind of breakout or detail.

Rick Allorto (CFO)

Yeah. A little bit. It's a little bit of both. Some of the equity co-invests performed well, in particular, a company called By Light as well as a company called Marketplace Events. Those two were the two kind of larger markups in the value of the equity. And then it is a broad portfolio move on the debt securities. As we've said, we think spreads have tightened about 50 bps over the last six or nine months, and that's kind of what you see in the general increases in the valuations on the debt securities.

Mark Hughes (Managing Director and Senior Equity Research Analyst)

And then you probably touched on this, but kind of your broader general credit outlook from a macro perspective as we think about going through 2024, any particular views on where things might be heading?

Rick Allorto (CFO)

Not really. We're not macro economists. We are micro credit underwriters. For lenders, flat is just fine if you've underwritten credit appropriately. We underwrite assuming there'll be some bump in the road early in the life of a loan. So we think we're well-positioned in any environment, but we don't have any for macro calls. I'm sure Truist has some expertise and others do. That's not really our strength.

Mark Hughes (Managing Director and Senior Equity Research Analyst)

Okay. Appreciate it. Thank you, Art.

Brian McKenna (Managing Director and Senior Equity Research Analyst)

Thank you.

Operator (participant)

We will now move to Vilas Abraham from UBS. Please go ahead.

Vilas Abraham (Analyst)

Hey, everybody. Thanks for the question. Can you talk a little bit about the timing of the liability actions PFLT took in Q1 and just how we should think about the average cost of debt trend into Q2?

Rick Allorto (CFO)

It's a great question. We've been talking about spread tightening and things are moving in a positive direction. Our securitization happened kind of in early February, so kind of early to mid-quarter. Spreads on CLOs have come down since then. I think we said we were about 230 over on the AAA on the PFLT securitization. We just priced a AAA, and we just priced the securitization for the JV. PFLT owns 87.5% of the JV with Kemper, and we just priced the AAAs at like 193. So we're going to get the benefit of some tightening that happened between early February, and here we are in early May. So we like the securitization financing. Again, we're never going to be smart enough to pick the optimal time. We just know that it's very good matching for our lower-risk first lien assets. It's 12-year money.

It's matched from a fixed standpoint. The structure of these securitizations are such that we never have to worry about a credit officer in a corner office having a bad hair day. They're very kind of self-correcting. So we were operating a middle-market CLO through COVID. It worked wonderfully during that period. So we really like the securitization structure. It's very matched and helps us sleep at night. And we also like our revolvers, and we also like our bonds, but securitizations are a very good tool for this kind of portfolio.

Vilas Abraham (Analyst)

Okay. All right. Then just on amendment activity, can you comment a little bit about what you're seeing there? I saw other income was a little bit elevated again in Q1. So just thinking about how we should look at that moving forward.

Rick Allorto (CFO)

Yeah. Look, amendments are part of our business. They always are. It's not that material at this point. There's a handful of names that tend to amend every quarter. Some are bigger. Some are lower. I think what we've seen, though, and the nice thing about how we lend with a loan-to-value so attractive, in many cases, as part of an amendment, we'll ask the private equity sponsor to inject additional equity beneath us. And in many cases, they do. For instance, rolling back the tape to COVID. In COVID, in almost every case, the sponsors put equity in to solve the problem. And that's what happens when you have well-structured covenants that have meaning, and that's what we do versus, let's say, what's going on in the upper middle market.

In the core middle market, we see covenants which get us to the table, which does create that opportunity to have that conversation to ask for more equity or to ask for additional economics, whether those be fees, as you said, or whether they be increased spread. So having the monthly financial statements and the quarterly maintenance test, the quarterly covenants, has been a good thing for us over time, most importantly in protecting and preserving capital. Of course, we make mistakes. We all do, but it's kind of, we kind of, through our structures, really try to minimize them.

Vilas Abraham (Analyst)

Got it. Appreciate the color. Thanks.

Rick Allorto (CFO)

Thank you.

Operator (participant)

We will take our next question from Gil Marsac from Knights of Columbus. Please go ahead.

Gil Marchand (Analyst)

Good morning. If you can, can you just give some background on the new non-accrual and the one non-accrual that came off?

Rick Allorto (CFO)

Sure. Thank you. Good question. The non-accrual that came off is a company called MailSouth or Mspark. Two different names. It was originally MailSouth. It might have been listed in our schedule of investments as such. The name changed to Mspark. We had already marked that down to zero in the prior few quarters, so that was just the company was sold. And in fact, we recovered zero, so that moved off our schedule of investments. And the one that moved on is a company called Walker Edison. Walker Edison did a restructuring a while back. It continues to not perform that well. We're optimistic, though. We think the sector over time will heal, but it's taking a while, so we proactively put that company on non-accrual.

Gil Marchand (Analyst)

Thank you. In a follow-up, Moody's came out yesterday with a report on middle-market CLOs saying the smaller companies were, I guess, more affected with higher rates. Just wondering if you could comment on that, Art?

Rick Allorto (CFO)

Yeah. Look, it's no shock that higher rates. We're in a higher-rate environment, and that's when people originally did these deals, no one anticipated the risk-free rate going where it is. On average, our companies are still covering their interest 2x, right, over 2x. So that's really a testament to how we structure the deals upfront more conservatively. When we did most of these deals prior to the interest rate increases, the interest coverage was over 3x, but now it's kind of over 2x, which makes sense. Again, we've still seen very light non-accruals and very light amendment activity, and I think that's really a testament to kind of the core middle market where leverage is lower. I don't know. You may follow some of our bigger peers who focus on the upper middle market.

Our sense is debt-to-EBITDA is higher than 4.5x or so, which is kind of where we underwrite, 4x. Our sense is interest coverage is tighter, and that's just, frankly, because of the supply-demand of capital. In the upper middle market, they've got a lot of money to put to work. They're "competing" with the broadly syndicated loan market and Wall Street, so there's a lot of dollars chasing those upper middle market opportunities. What's resulted is it's orphaned kind of the core middle market companies. So we have a playing field below 50 EBITDA where there's a few of us who are active. The competition's less. Our capital's very meaningful to those borrowers. We can still get meaningful covenants.

We get the monthly financial statements, so the overall package of risk-reward is very attractive, and we think appropriate for the size of these companies.

Gil Marchand (Analyst)

Thanks, Art. And lastly, the fund is doing well, and the metrics are very good. Have you thought about talking to Moody's or S&P or Fitch to get another rating?

Rick Allorto (CFO)

Yeah. I mean, just to be so it's interesting. S&P does rate our CLOs and does give us ratings estimates for all of the loans that go in our CLOs. So basically, all of our senior loans get ratings estimates. When we walk into the securitization side of S&P, they say, "Gee, the top 65% of this stack, we're going to rate AAA," right? We can issue AAA. We just issued AAA at 193 the other day in the JV. Essentially, when you're getting 2-to-1 leverage in those CLOs through that portal of S&P, S&P thinks that you can leverage their assets 2 times, and it's a AAA.

Then when you walk into the other door at S&P, which the name on the door says BDC, that door at S&P says, "Whoa, you can't leverage more than 1.25x and be BBB on an unsecured basis." So there's a bit of an inconsistency going on at S&P. We try to highlight it to them. We're happy to talk to them, and perhaps you can talk to them. But if one portal of entry is giving us a 2-to-1 leverage through a securitization at AAA, it would appear to us that that's a very efficient way to do it versus going into something called the BDC room where they have a much different view of credits, which are, by the way, the same exact credits, whether we're doing unsecured at the BDC level or securitization either in the BDC or at the JV.

So happy to talk to you about this at your convenience, Gil, but it's very interesting.

Gil Marchand (Analyst)

Thanks, Art.

Rick Allorto (CFO)

Thank you.

Operator (participant)

Art, I'd like to turn the conference back to you for any additional or closing remarks.

Rick Allorto (CFO)

Thank you. Just want to thank everybody for being on the call today. Next time we'll be talking will be after our June quarterly earnings, which will be in early August. In the meantime, wishing everybody a great spring and summer. Have a good day.

Operator (participant)

This concludes today's call. Thank you for your participation. You may now disconnect.