PennantPark Floating Rate Capital Ltd. Q2 FY2020 Earnings Call

Good morning and welcome to the PennantPark Floating Rate Capital's Second Fiscal Quarter 2020 Earnings. 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.

Thank you and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's second fiscal quarter 2020 earnings conference call. Joined today by Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

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. 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.

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 want to spend a few minutes discussing our portfolio going into the COVID-19 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&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 have been preparing for an eventual recession for some time. Prior to the COVID-19 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 31, 91% of the portfolio was in first lien senior secured debt with a weighted average yield of 7.8%. The portfolio is constructed to withstand market and economic volatility. As of March 31, average debt-to-EBITDA on the portfolio was 4.2 times and 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 that are 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. PFLT 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-19, 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 in 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 shown over the past year. Our credit quality since inception nine years ago has been excellent and in 380 companies in which we have invested since inception, we have only experienced nine non-accruals. Since inception, PFLT has invested over $3.7 billion, at an average yield of 8%. This compares to an annualized realized loss ratio of only 7 basis points annually. If we include both realized and unrealized losses including the unrealized losses through March 31, the annualized loss ratio was 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 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 million 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 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 they requested 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 confident that most of the loans in our portfolio benefit from real covenants that would 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 2021. Two of the other gaming companies are undertaking construction phase projects, which provide them with interest reserves into mid-2021. The other four properties are regional facilities whose 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, they will have cash on the balance sheet that will allow a 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 Aviv 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 1.57 times while GAAP net debt-to-equity after subtracting cash was 1.5 times. The regulatory debt-to-equity ratio was 1.81 times and our regulatory net debt-to-equity ratio after subtracting cash was 1.74 times. As many of you know, in early 2009, in response to the global financial crisis, we started marketing 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 regulatory asset coverage purposes, they would prefer remark liabilities at cost, not market, 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. If liabilities were not marked to market, the 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 funding revival draws and were 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 sustain 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 million of revolving credit facility maturing in 2023 with a syndicate of 11 banks, $413 million drawn as of March 31, the $139 million of unsecured senior notes maturing in 2023, and $228 million of asset-backed debt associated with Pennantpark CLO through 2031. We're paying a 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 and 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 4.2 times. Translating this into the language of value investors, at the stock price of PFLT today, well below NAV, we and shareholders own a portfolio of companies at a multiple of about 2.6 times cash flow, even in a recession with potential declines in cash flow value investors should be able to appreciate an attractive low multiple. As previously disclosed, directors, officers, and employees of PennantPark investment advisers purchased about 535,000 shares of PFLT 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.

Thank you, Art. 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 $5.9 million, taxes, general and administrative expenses totaled about $1 million, and interest expense totaled about $7.6 million. During the quarter ended March 31, net unrealized depreciation on investment was about $65 million or $1.67 per share. Net realized losses was about $1.6 million or $0.04 per share. Net unrealized appreciation of our credit facility and notes was $0.86 per share. Net investment income exceeded the dividend by $0.02 per share. Consequently, NAV went from $12.95 to $12.12 per share. Adjusted NAV excluding the mark-to-market of our liabilities was $11.10 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 main are marked-to-market by our Board of Directors each quarter using the equity price provided by an independent valuation firm or exchanges or independent dealer quotes when active markets are available under ASC 820 and 825. In cases where both the other 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 secured debt, including 10% in PSSL, 3% in second lien, and 6% in equity including 4% in PSSL. Our overall debt portfolio has an 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 Art.

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, as a high free cash flow conversion. We see our free cash flow primarily in first lien senior secured instruments. We pay out those contractual cash flows in the form of dividends to our shareholders. 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 for questions.

And we'll go first to Mickey Schleien of Ladenburg.

Yes. Good morning. 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?

The average EBITDA is – Mickey can you hear me?

Yes.

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

Right in the middle market level and what trends could you see in the first quarter?

Look we had a very strong first calendar quarter. We had a very strong quarter up until the end of March. So, we saw very strong performance across the portfolio going into the COVID-19 crisis.

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

Yeah. 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, 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 an 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 have been helpful.

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

Yeah. So in the normal market we've been saying 1.4 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 even 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-19 risk. 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 plus quarter end and still we want to create more cushion and more liquidity in the system.

Great. That’s good to hear. Those are all my questions. I appreciate your time, and I hope everyone there is safe and healthy.

Thank you, Mickey. You too.

And next we'll go to Ryan Lynch of KBW.

Hi, good morning. Thank you for taking my questions, and hope you guys are all doing well and safe. My first one just has to do with your asset-backed notes. As we evolve through this process, I think we've seen that the asset-backed notes or securitizations or CLOs for different BDCs can be seen as the most concerning liability tranches because they're not as flexible. They don't work with a banking partner and 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?

Yeah. Thanks Ryan and 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 manage but there are 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 a Triple B tranche. So it's a less levered CLO to begin with.

Okay. And then what about the credit facility that you guys had in PSS, can you talk about your comfort around that a little bit that's high leverage as well? Can you talk about your gas comfort with the ability to not have any covenants on that?

We have a joint venture called PSSL with Kemper, and the bank involved is Capital One, along with a group of other banks. We've been having positive discussions with Capital One, keeping them well-informed about the portfolio's status. These discussions are continuing, and we feel optimistic about the relationship. On a broader scale, we have communicated clearly with U.S. banking regulators, including the Fed and the OCC, regarding the challenges posed by COVID-19 and encouraging banks to be flexible and supportive of borrowers during this time. Throughout our interactions with various banks in the PennantPark platform, we have witnessed commendable behavior, supported by our long-term partnerships. The ongoing challenges of COVID-19 are significant, but our banks appear to recognize that reality.

Okay. And then I know you guys touched on this earlier and you provided some comments around the gaming industry, you talked about four of your properties or regions. No, you don’t have to get on a plane. I understand some construction slowdowns and kind of looking into a higher quality investment-grade company. But just can you talk about 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 runway to conserve cash for the longer term. And then lastly just what is the ultimate outlook of those businesses in your mind right now? Obviously, it's going to be largely dependent on when the economy opens, but I would think that some of those businesses may be some of the last ones to be able to open just because of crowded places that aren't really essentials. So just any additional commentary would be helpful on that.

Sure. I believe you have addressed all the important points. If a company has significantly reduced costs to the bare minimum and laid off or furloughed employees, it means they are focusing on maximizing liquidity in every possible way and ensuring they have enough runway during this shutdown. Generally, most companies have managed their liquidity effectively and minimized ongoing costs. From what we've observed, they appear to have sufficient runway to navigate a gradual reopening over time, and even as businesses start to reopen, there will likely be a slow increase in customer traffic. We think they have handled the situation well, especially since most of them operate regional facilities with local customers, which makes them well-prepared for a prolonged period of reduced activity. The strategy is in place, they have followed it, and now we just need to see how the situation unfolds.

Okay. Makes sense. Draw all my questions. I appreciate the time today.

Thanks Ryan.

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

I apologize for that. Art, I have a question for you. I remember when you decided to market liabilities to market, and we had some great discussions about that. One of the main points you made was about better aligning the movement of the asset side of the balance sheet with the liability side. I recall that being very beneficial for PNNT during the financial crisis of 2008. Could you share some details about what the SEC mentioned when they showed a preference for a cost-based mark on your liabilities? I assume you pointed out that this would create better alignment on both sides of the balance sheet. What was the nature of that conversation?

Yes, I'm laughing because these are very quiet conversations and just suffice to say that we really liked the marketing liabilities to market for a lot of reasons including the reduction of volatility and also for SEC asset coverage purposes to the extent you can use it, it's a terrific insurance policy. It 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 a decade the guidance 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 assets. And certainly it's already part of our GAAP financial statements. The way it works is every time you take down a liability whether it be a credit facility or a bond, you have a one-time option to mark that liability to mark it under GAAP. So, that's what we have been doing until recently using that option under GAAP and until recently GAAP and regulatory asset coverage were virtually the same because you had very calm markets. So, here we are in a volatile market as of March 31 and for GAAP purposes we mark many of our liabilities to market which does the volatility of NAV but does not get taken into account for the regulatory asset coverage test which is kind of why we're now adjusting NAV per share which takes out the mark-to-market of reliability. It makes it complex. I apologize to everybody. It was done with the benefit of intentions of reducing the risk in 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 at doing it. In terms of the dialogue, I do about had the dialogue, it was attorney dialogue with the SEC and our attitude is when the SEC guides us to do something we should be listening to that. So we are listening to our guidance and we still are in fine shape as you've seen. We'd be in better shape in some sense if we hadn't, but it is what it is and we will live out the constraints that we're given at this point in time.

I appreciate that. I recognize that the data is quite complex, and whether or not the best disclosure is to market remains in question. However, I believe we now have witnessed two distinct cycles of extreme market conditions or liquidity that demonstrate this can mitigate some of the significant fluctuations occurring in BDCs and net asset value. I was somewhat surprised by the information in the OR, but I acknowledge that there has been some retail activity influencing that interpretation. Thank you for your insights. The other question I had is regarding your deal flow. You mentioned having numerous opportunities to deploy capital at present that appear quite appealing. This seems somewhat contrary to what we've gathered from some lenders operating in what you refer to as the upper middle market, typically involving $75 million to $100 million EBITDA. There's a sentiment that currently, it is challenging for borrowers and lenders to agree on terms. In terms of the $35 million to $40 million range, do you believe there is a deeper market activity occurring in that lower middle market segment right now?

Just to clarify, there isn’t a significant amount of deal flow currently in the primary market. We are seeing some deal activity in sectors that have been relatively unaffected, such as certain contractors and government services, which continue to operate steadily. This sector represents a substantial part of our portfolio. While there are still private equity sponsors attempting to complete transactions, the level of deals is not as high as in the past. Although the market is quiet, both buyers and sellers, as well as lenders, are assessing risk-adjusted returns for companies not impacted by COVID, and there is some activity occurring in that area. Overall, it has been a slow period. There are some secondary opportunities that seem promising. For PFLT, our primary focus right now is on our portfolio. We will consider new investments selectively, but the standards are quite high at this time. Our priority is to concentrate on our existing portfolio companies first.

Okay. Thank you for the clarification. Sorry, I got that wrong.

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

Thank you everybody for listening in today. We appreciate and 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.

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.