Pennantpark Floating Rate Capital - Earnings Call - Q3 2021

Transcript

Speaker 0

Good morning, and welcome to the PennantPark Floating Rate Capital's Third Fiscal Quarter twenty twenty one Earnings Conference Call. Today's conference is being recorded. At this time, all participants have been placed in a listen only mode. The call will be open 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 third fiscal quarter twenty twenty one earnings conference call. I'm joined today by Richard Chung, our new Chief Financial Officer. Richard joined us in June from Guggenheim Partners, where he was Head of Alternative Investment Accounting for many years. Prior to Guggenheim, he was at EMY.

We are thrilled that Richard has joined us and are confident that his extensive experience will be a tremendous asset to the company. We thank Aviv Efraat for all his contributions to PFLT since inception and are grateful that he is continuing with PennantPark focusing on strategic initiatives. Richard, please start off by disclosing some general conference call information and include a discussion about forward looking statements.

Speaker 2

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 Flooring Red 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 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.

Speaker 1

Thanks, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials and then open it up for Q and A. We are pleased with our performance this past quarter. Our net investment income grew to $0.27 per share, while our credit quality and NAV performance remained solid. We are poised to significantly grow NII through a three pronged strategy, which includes: number one, growing assets on balance sheet at PFLT as we move towards our target leverage ratio of 1.5 times debt to equity from 1.1 times number two, growing our PSSL JV with Kemper to about $730,000,000 of assets from approximately $500,000,000 and number three, rotating the equity value in the portfolio that has come from our strong equity co investment program into cash paying debt instruments.

With regard to the PSSL JV, with the CLO financing we completed earlier this year as well as additional capital contributions from PFLT and Kemper, the JV will grow over time. The capital contributions from PFLT are targeted to generate a 10% to 12% return. During the June, PFLT invested $20,000,000 of capital and we intend to invest another $42,000,000 over time in order to bring PFLT's investment into PSSL to approximately $243,000,000 As part of our business model, alongside the debt investments we make, we selectively choose to co invest in the equity side by side with the financial sponsor. The returns on these equity co investments have been excellent over time. Overall for our platform from inception through June 30, our $237,000,000 of equity co investments have generated an IRR of 28% and a multiple on invested capital of 2.9 times.

In a world where investors may want to understand differentiation among middle market lenders, our long term returns on our equity co investment program are a clear differentiator. We are well on our way to implementing the NII growth strategy. Since June 30, PFLT has had new originations of $102,000,000 and PSSL has had new origination of $29,000,000 Although in the June repayments exceeded new loans, in the September so far, repayment activity has abated and new originations have accelerated. Our portfolio performance remains strong. As of June 30, average debt to EBITDA in the portfolio was 4.2 times and average interest coverage ratio, the amount by which cash income exceeds cash interest expense was 3.3 times.

This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. We have only two non accruals out of 105 different names in PFLT and PSSL. This represents only 2.8% of the portfolio at cost and 2.7% at market value. We have largely avoided some of the sectors that have been hurt the most by the pandemic such as retail, restaurants, health clubs, apparel and airlines and PFLT also has no exposure to oil and gas.

The portfolio is highly diversified with 100 companies in 42 different industries. Our credit quality since inception over ten years ago has been excellent. Out of three eighty one companies in which we have invested since inception, we have experienced only 14 non accruals. Since inception, PFLT has invested over $4,200,000,000 at an average yield of 8%. This compares with a loss ratio of only seven basis points annually.

We are 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 was investing at that time. During that recession, the weighted average EBITDA of our underlying portfolio companies declined by 7.2 at the bottom of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%. Based on tracking EBITDA of our underlying companies through COVID, our EBITDA decline was substantially less than it was during the global financial crisis.

Our median EBITDA decline at the bottom of COVID in June 2020 was 1.4%. This compares favorably to the 7% decline in EBITDA during COVID of the Credit Suisse high yield index. Many of our portfolio companies are in industries such as government services, healthcare, technology, software, business services and select consumer companies and where we have meaningful domain expertise. The outlook for new loans is attractive. We are as busy as we've ever been in fourteen years in business, reviewing and doing new deals.

With our experienced, talented and growing team, our wide funnel is producing active deal flow that we can then carefully and thoughtfully analyze so that we can be selective as to what ends up in our portfolio. We are focused on the core middle market, which we generally define as companies with between 10,000,000 and $50,000,000 of EBITDA. We like the core middle market because it is below the threshold and does not compete with the broadly syndicated loan or high yield markets. As such, we do not compete with markets where leverage is higher, equity cushion lower, covenants are light, wide or nonexistent, information rights are fewer, EBITDA adjustments are higher and less diligent and the timeframe for making an investment decision is compressed. On the other hand, where we focus in the core middle market, generally our capital is more important to the borrower.

As such, leverage is lower, equity cushion is higher, we have real quarterly maintenance covenants, we receive monthly financial statements to be on top of the company's, EBITDA adjustments are more diligent than achievable and we typically have six to eight weeks to make thoughtful and careful investment decisions. According to S and P, loans to companies with less than 50,000,000 of EBITDA have a lower default rate and a higher recovery rate than those loans to companies with higher EBITDA. Let me now turn the call over to Richard, our CFO, to take us through the financial results in more detail.

Speaker 2

Thank you, Art. For the quarter ended June 30, net investment income was $0.27 per share. Looking at some of the expense categories, management fees totaled about $4,300,000 Taxes, general and administrative expenses totaled about $450,000 and interest expense totaled about $5,900,000 During the quarter ended June 30, net unrealized appreciation on investments was about $14,000,000 or $0.37 per share. Net realized losses were about $13,000,000 or $0.33 per share. And changes in the value of our credit facility and notes increased NAV by $0.08 per share.

Net investment income was lower than the dividend by $02 Consequently, GAAP NAV went from $12.71 to $12.81 per share. Adjusted NAV, excluding the mark to market of our liabilities, was $12.62 per share, up from $12.6 per share. Our entire portfolio, our credit facility and also marked to market by our Board of Directors each quarter using the exit price provided by an independent valuation firm exchanges independent broker dealer quotations when active markets are available under ASC eight twenty and eight twenty five. In cases where broker dealer quotes are inactive, we use independent valuation firms to value the investments. With ample liquidity and prudently levered, our GAAP debt to equity ratio was 1.1 times, while GAAP net debt to equity after subtracting cash was one time.

Regulatory debt to equity ratio was 1.2 times and our regulatory net debt to equity ratio after subtracting cash was 1.1 times. With regard to leverage, we have been targeting a debt to equity range of up to 1.5 times. We have a strong capital structure with diversified funding sources and no near term maturities. We have a $400,000,000 revolving credit facility maturing in 2023 with $133,000,000 drawn as of June 30. January of unsecured senior notes maturing in 2023, dollars $228,000,000 of asset backed debt associated with PennantPark COO one due 2031 and $100,000,000 of unsecured senior notes maturing in 2026.

Our portfolio remains highly diversified with 100 companies across 42 different industries. 85% is invested in first lien senior secured debt, including 14% in PSSL, 2% in second lien debt and 13% in equity, including 5% in PSSL. Our overall debt portfolio has a weighted average yield of 7.5. 98% of the portfolio is falling rate and 82% of the portfolio has a LIBOR floor. The average LIBOR floor is 1%.

Now let me turn the call back to Art.

Speaker 1

Thanks, Richard. 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. We try to find less risky 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. 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 would like to open up the call to questions.

Speaker 0

Thank And we'll now take our first question. It comes from Mickey Schleien from Ladenburg. Please go ahead.

Speaker 3

Morning, Art, and welcome, Richard. Art, this quarter, I'm seeing mixed results in terms of the market opportunity, and I'd appreciate your insight. Clearly, the private debt and private equity markets have a lot of dry powder and spreads are tightening, which can result in a high level of repayments as we've seen at PFLT year to date. On the other hand, as you know, the economy is growing sharply and M and A is very active. I think borrowers also seem to be moving toward private debt solutions.

I understand that repayments can be a function of vintage and call protection. But broadly speaking, I'd like to understand how you expect your portfolios across the Pennant platform to develop in the second half of this year and maybe going into next.

Speaker 1

Thanks, Mickey, and good morning. Quarter to date repayments have been light and new originations have been heavy. So last quarter, were a lot of repayments. This quarter so far, we've seen lighter repayment. We're seeing a lot of new companies come in.

Sometimes there's the same old companies that get recycled and they go from one private equity firm to another or one private lender to another. This quarter, we're seeing many more new companies come into the system. Usually and again, we're focused on kind of the 10 to $15,000,000 of EBITDA space as we talked about. In many cases, the deals that we're doing, it's the first time there's institutional capital in a founder owned business or a family owned business or an entrepreneur, and the private equity sponsor is buying that company's that first institutional capital, that first institutional equity and we're the first institutional debt. So we're kind of on the front lines of bringing new growing companies into the system.

And over time, they may grow from 15,000,000 of EBITDA to 15,000,000 or $16,000,000 and they end up going off to the broadly syndicated market or going off to the big cap sponsors. But where we play and where we're getting our best returns is when those companies are starting out at a 10 to 20 EBITDA, the sponsor sees a fragmented industry or an organic growth opportunity, they're willing to plow a lot of equity behind it, which is great cushion for us. Our debt can help fuel that growth. Our equity co invest can participate in the upside of that growth and it ends up being a nice win win. So this quarter, just to answer your question, we're seeing many more new companies come into the system versus the recycling of some very good older companies.

We for instance, we had an exit over in PNNT and Decopac. It's a great company. It went off to another sponsor and another direct lender, but the company is now bigger than when we started with it.

Speaker 3

Thanks for that, Art. And that kind of leads into my next question in terms of the target market. Can you remind us what the average size of the borrower is in the PSSL portfolio compared to your own balance sheet portfolio? And how would you compare the investment opportunities in those two segments?

Speaker 1

Look, PSSL is roughly similar to PFLT. PSSL gives us an ability to write a bigger check and solve a borrower problem, bring some smart institutional capital like Kemper into our ecosystem and also offer a higher ROE for PFLT shareholders. So roughly the same portfolio just increases the wingspan, the bite size and it's very accretive for PFLT shareholders. So average EBITDA is 25,000,000 to 30 in both vehicles. Now some of those were companies where we started out at 15 or 20 and they've grown.

Some of those companies started out at 30 or 40. So it's a blend of the two. And the entire portfolio doesn't start out at 10 or 20, but a chunk of it does and that tends to be the ones where those equity co invests can be so valuable when we are helping fuel the growth of that company up to a bigger company, where there's a sponsor who sees a real opportunity for growth and is willing to plow substantial equity behind that opportunity. So blended, it's still 25 $30,000,000 Some are bigger companies from the get go. Some are smaller companies that have grown up.

Speaker 3

And Art, how can you remind us how you allocate them between those two portfolios given that the borrowers are similar?

Speaker 1

Yes. So it's each portfolio has to stand on its own two feet and have proper diversification. So we want at least 50 names in each portfolio, which we have, and we want to be increasingly diversified. And that's a smart way to run a senior loan book. So they're both highly diversified portfolios.

It's based on available capital. There's an available capital calculation. It's mathematical that when a deal gets done, there's a mathematical calculation that's done based on available capital. And again, PFLT owns 87.5% of the joint venture. That's a pretty substantial ownership.

Speaker 3

Right, in terms of the economics. Lastly, a housekeeping question. I don't know if it's for you or for Richard, but what was the main driver of your realized loss this quarter?

Speaker 1

Yes. It's we had we did have a nonaccrual we had additional nonaccrual, American Teleconferencing, which is called Premier Global. That was unrealized loss. The main driver of the realized loss was Country Fresh, which was a nonaccrual, which went through bankruptcy and is now not on the balance sheet anymore. That was the main driver of the realized loss.

Speaker 3

I understand. That's it for me. Thanks for your time. And again, welcome, Richard.

Speaker 1

Thanks, Becky.

Speaker 0

We'll now take our next question. It comes from Ryan Lynch of KBW. Please go ahead.

Speaker 4

Hey, good morning. Thanks for taking my questions. The first one is kind of a follow-up to previous questions regarding the balance sheet and the PSSL. Because you mentioned the several goals for increasing operating earnings, increasing leverage, increasing the portfolio size of PSSL. Well, on those first two goals, they're both kind of feeding off the same deal flow that PennantPark as a platform is bringing in.

So assuming that deals fit both of those strategies, which it sounds like they do, is there any preference to grow one versus the other, meaning add more balance sheet leverage versus try to ramp up the PSSL, which is with the leverage within that fund, it's kind of a higher yielding entity. Is there any preference one versus the other? I know they're both a goal, but they kind of conflict with each other as far as your originations go, where they can be placed.

Speaker 1

Yes. It's a great and nuanced question, Ryan. And wouldn't say they necessarily conflict, but I would say they work in a complementary fashion. PFLT itself, we're our target leverage over time is up to 1.5 times. We have credit ratings to think about there.

We have some unsecured bonds to think about there. We have where market convention is. These assets that we're putting in both PFLT and PSSL, we also put in CLOs outside of the BDCs that we run. So you can put the same again, if you look at the underlying assets that we have in PFLT and PSSL, they're among the lowest yield, lowest risk assets in the BDC industry. Our expense load is commensurately low as a result.

We think we can also run these same assets safely in a CLO format at three or four times debt to equity, and we have, and we've run them safely through COVID. Outside the BDCs, could run them in a more leveraged fashion. In PSSL, we probably would target running them in a more leveraged fashion than 1.5 times debt to equity. Again, why is it and why can't it be so accretive for PFLT is because in the JVs, we do target running the leverage a bit higher than that 1.5 times. So if you said we've stated publicly here today, our target over time for the JV is $750,000,000 excuse me, $730,000,000 of total bite size and total junior capital is $275,000,000 By definition, the leverage is higher.

Speaker 4

Understood. And then as you guys are looking to deploy capital out in the market, certainly, overall market activity has increased, but obviously competition has kind of resumed back to pre COVID levels. I'm just curious, do you guys use any sort of macroeconomic backdrop as kind of a base case when you guys are underwriting these loans? Obviously, you guys are going to do a bottoms up due diligence on each loan. But you guys look at a loan today with same terms that a loan maybe had in 2018, 2019 as a better risk or a better proposition, just given that the economy today is kind of on an upswing from our credit cycle versus in 2018, 2019, we were ten years removed from the last credit cycle.

Does that inform your guys' willingness to deploy capital in today's environment? Obviously, knowing that it's going to be ultimately a bottoms up approach per credit, but did you guys use that macroeconomic backdrop to kind of inform how aggressive you'll be in today's market?

Speaker 1

Yes. It's a good question, and we do. I mean, just if you look back at the 2017 to 2019 time period, we were very public and others were too, that we were getting concerned that the cycle was getting long in the tooth and there would be some sort of softness. Of course, we never could have predicted COVID, but I think a lot of us, and we were public about it, thought that we're getting late in the cycle and we're therefore operating in a more defensive posture. Today, we see it in our portfolio companies.

We get the monthly numbers. The economy is in a strengthening position, sometimes quite dramatically. So for sure, we feel more comfortable playing offense as a general macro matter today than we did, say, 2017 to 2019. That said, you're right, it's bottoms up industry by industry specific. The companies that we're financing today all came through COVID in very strong fashion.

So in many cases, benefited from COVID. So we are playing a little bit more offensively, a little bit more offensive posture. And these are companies that we think are very high quality companies that we're prepared to back. One of the big lessons for us over all of our years in business, you got to find the right companies. You got to pick the right companies.

And you can stretch a little bit on leverage. You might be able to be willing to stretch a little bit on yield. If you find the right companies, the rest of it takes care of itself. And that's the business we're in.

Speaker 4

Yes, that makes sense. And then the last one that I had was, I know PFLP equity portfolio is smaller than PNNT, and I know PNNT has some cash proceeds. I was curious, did PFLP have any level of cash proceeds either from like dividends, dividend recaps or anything like that or actually exits this quarter? And what is your outlook as far as obviously that's one of your goals of equity rotation? What is your outlook on your ability to have meaningful equity exits over the next twelve months or so?

Speaker 1

Yes. It's a good question. So PFLT and PNNT are roughly the same investment size in Walker Edison. So last quarter, and we'll talk about it a little later, I mean, there were two capital events for Walker Edison in this past quarter. One was a dividend recap, where two times we got back two times our money on the equity and then there was an investment by Blackstone, where we got another 2x our investment.

So that was a nice cash realization on Walker Edison that came our direction on equity. Just looking at the quarter, I mean, that was the big one. That was about four point that was a realized gain of about $4,300,000 in the quarter. It was offset by Country Fresh. The realization of the Country Fresh loss offset that.

We had about a $1,400,000 realized gain on DecoPac equity. And we had about a $700,000 gain on WBB equity. So some of the same names, different order of magnitude in PFLT. Going to the book itself and the equity co investor, you can see there's some that are performing very well based on the marks. Bylight is one

That's about a $12,000,000 market value there. We've got a company called Infosoft, $3,500,000 excuse me, about $5,700,000 of equity. GComm, a little over $4,000,000 of equity. KNOW is in PFLT as well, 7,600,000.0 of equity. There's still another $6,900,000 of equity value in Walker Edison.

So still some nice equity bites to be potentially exited and rotated over the coming year or two.

Speaker 4

Okay. That's helpful detail. I appreciate the time today.

Speaker 1

Thank you, Ryan.

Speaker 0

We'll now take our next question. It comes from Devin Ryan of JMP Securities. Please go ahead.

Speaker 5

Great. Good morning, Art and Richard. Just a couple of follow ups from us. I guess, the first one, the past couple of quarters, you had, I believe, characterized the current vintage of loans being the most attractive in the past decade or so. And I'm just curious if that's still the case today.

I suspect that speaks to strong originations and offensive posture. But how is the pipeline evolving, I guess, recently from an attractiveness perspective? And is there any other, I guess, color you can share around that?

Speaker 1

Yes, it's a good question, Devin. The best thing about the Vintage is, again, the companies that we're financing today came through COVID in really good shape, in some cases strengthened through COVID. We're in the credit selection business. We have to pick good credits. We have to avoid mistakes.

So the quality of the company is paramount. And that's the most attractive thing is we're seeing companies that have come through the last couple of years of chaos and uncertainty with a strong posture, which gives us confidence that our capital will be preserved in some cases with the equity co invest be capable, we'll be increasing value through these equity co invests. So that's really the most attractive thing. And look, the deal machinery was put on hold for a year and a half, right? There were no deals or very little deals.

So all of this pent up deal demand is kind of coming to fruition today, and that's one of the things driving it. We also think there's a piece of it that's potentially focused around the potential capital gains increase sometime in the future and a desire by some sellers to capture a gain before potential capital gain increase. So I think that's playing into it a little bit, kind of the pent up demand from one years point and the potential capital gains increase on the horizon are both working together to bring a lot of deals.

Speaker 5

Yes. Okay, great. Now that makes a lot of sense. Thank you, Art. And then just follow-up on one of your prior comments just about recent repayment activity slowing.

I know it's episodic, but do you see any trend there around that? And are there any other factors that you see shipping?

Speaker 1

Yes. I mean, it could be, and I'm just making a supposition, Devin, that as I said earlier, we're seeing more new names to our ecosystem. The repayments and refis are done with names that are already in the ecosystem. It's an opportunistic market, the company is getting sold or there's a refi or whatever. And when you're bringing new companies into the ecosystem, and they may be companies that we start out with where it starts out with 10 to 20 of EBITDA and in three years it's a 50 and it goes to somewhere else in our ecosystem, maybe the mega lenders or whoever, the big private equity shops.

Today, we're seeing more new names that are new to this middle market credit, middle market direct lending ecosystem. And again, many of the companies that we see where we are focused are this is the first institutional capital. It's a family, it's an entrepreneur, it's an owner, a family who is selling their baby that they've built up over twenty, thirty, forty, fifty years and they're selling it to a private equity firm. And it does 10,000,000 or 15,000,000 or 20,000,000 or 25,000,000 of EBITDA and it's the first time institutional capital has been in there. And that private equity firm brings all kinds of things like audited financial statements and policies and procedures and financial controls with the goal of taking that 15,000,000 or $20,000,000 EBITDA company and getting it to 40,000,000 or 50,000,000 or 70,000,000 We're the first kind of private debt lender in that company.

Our debt helps fuel that growth from $20,000,000 to 50,000,000 In certain cases, and this has worked, we've co invested in the equity and we're helping we're participating in that upside that we're helping to create with our debt capital. So I'd say I'm making a supposition that this quarter we're seeing many more new names into the ecosystem than we were last quarter where it was just refinancing the same old names. Some of the same old names are very good names, but the same old names.

Speaker 4

Yes.

Speaker 5

Okay, terrific. Yes, appreciate it. A little bit of a crystal ball question, but that's great color. So I'll leave it there. Thank you.

Speaker 0

This concludes our question and answer session. I'd now like to hand the call Art Penn for any additional comments or closing remarks.

Speaker 1

Good morning. Just thank everybody for their participation today in the call. And our next call will be in November. It's our 10 ks, so it'll be slightly later in the quarter than our normal Qs. But kind of mid November timeframe, we'll have our next quarterly conference call.

In the meantime, I hope everybody has a great and safe summer. Thank you very much.

Speaker 0

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