PennantPark Floating Rate Capital Ltd. Q4 FY2020 Earnings Call

Good morning and welcome to the PennantPark Floating Rate Capital Fourth Quarter 2020 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.

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Fourth Fiscal Quarter 2020 Earnings Conference Call. I'm 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 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 www.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. I'm going to spend a few minutes discussing how we fared in the quarter ended September 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, and the financials. Despite the challenging economic conditions brought on by the pandemic, we are pleased with our performance this past quarter. We achieved a 3.2% increase in adjusted NAV as our portfolio continued to improve during the quarter. We have several portfolio companies in which we have substantial equity positions that are benefiting from the K-shaped recovery. This is solidifying and bolstering NAV. Over time, rotation of debt equity into debt instruments should help grow PFLT's income. We will highlight those companies in a few minutes. Additionally, we've been pleased with the stable performance of our long-term securitization CLO financing through COVID. Debt financing has continued to perform well and is well matched to finance our senior debt positions, which we believe are among the lowest risk in the industry. As a result, we are exploring using the same type of financing to grow and efficiently finance PSSL JV, which should generate additional income for PFLT. The combination of potential income growth from equity rotation, and the larger, more efficiently financed PSSL should help grow PFLT's net investment income relative to dividends over time. Those factors, combined with strong portfolio performance through COVID and $0.22 spillover, have led us to conclude that we will be keeping our dividend steady at this point. 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 strategically positioned the portfolio to be as defensively resilient as possible.

Thank you, Art. For the quarter ended September 30, net investment income was $0.27 per share. Looking at some of the expense categories, management fees totaled about $4.8 million. Taxes and general administrative expenses totaled about $1.1 million, and interest expense totaled about $5.5 million. During the quarter ended September 30, we had about $20 million or $0.51 per share in net unrealized appreciation on investments. Net realized losses were about $4.7 million or $0.12 per share. Net unrealized depreciation on our credit facility and notes was $0.22 per share. Net investment income was lower than the dividend by $0.02 per share. Consequently, GAAP NAV went from $12.16 to $12.31 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.81 per share, up 3.2% from $11.44 per share last quarter. Our entire portfolio, as well as our credit facility and notes, are marked to market by our Board of Directors each quarter using the exit price divided by any independent valuation firm exchanges or independent broker-dealer quotations when active markets are available under ASC 820 and 825. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value investments.

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; 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.

We take our first question from Paul Johnson at KBW.

Hey, good morning, guys. Thanks for taking my questions. Congratulations on the Cano Health acquisition; it's obviously very positive news yesterday. But I just have a few questions here today. Over the last few quarters, no investments have been fairly muted, understandably so. I'm just kind of curious, now that you're back sort of within the leverage target, what is your outlook for new investments going forward? Can we expect to see maybe more active origination? Also, for any sort of new investments that you are looking at today, what is the environment that you're seeing? Are you still able to extract the same sort of covenants as before? Has that diminished? Any commentary on that would be very helpful.

Perfect, thanks, Paul. Yes, for the last couple of quarters, we've been evaluating the economy and our portfolio, and we are indeed back actively originating deals for both PFLT and PSSL. We also are getting repayments as part of that, so the wheels of commerce are starting to move again. We are actively looking and doing deals. So target leverage is still in that 1.5x zone of debt-to-equity, as we say. We think our portfolio is among the lowest risk in the industry. You could see it in the yields; our first lien typically is a lower-yielding first lien, maybe more of a classic first lien than some of the others, which means we believe that we can comfortably remain in that 1.5x leverage zone while feeling very safe and prudently capitalized in terms of the debt-to-equity ratio because the risk we're taking is lower than most and is lower than the industry. In terms of the risk-reward we're seeing, we tend to focus on companies with an EBITDA average between $15 million and $50 million, specifically $20 million to $30 million in this portfolio. We prefer to stay away from the fray of the broadly syndicated loan market, which has bounced back dramatically, where it's all covenant-lite with low yields and high leverage. Our larger competitors who have to write bigger checks are competing against the broadly syndicated loan market and accepting lower covenants, lower yields, more EBITDA adjustments, etc. With us, we always have covenants; even pre-COVID, we're getting tighter covenants now. We’re experiencing fewer EBITDA adjustments; if we accept them, they are thoroughly due diligence. We are seeing more equity from our sponsors and higher yields. The overall package of risk-adjusted return that we're seeing today versus pre-COVID is better, and much better, which is why we think this vintage could mirror the vintage of 2009 to 2012. I don’t think it will be as good as 2009, where the average debt-to-EBITDA was 3.3x, as our Central Bank and the fiscal authorities have reassured that we won't see that repeat, but we believe the upcoming vintage will look a lot like 2009 to 2012. So we are excited about what we're seeing and we are active.

That's good; that's very good to hear. Do you ever see a time where you guys have built a very high-quality, more conservative traditional first lien portfolio? In that environment, do you see any opportunity or have any thoughts around potentially getting slightly more aggressive to enhance the portfolio yield or top-line return? Or are you thinking of potentially doing slightly more aggressive deals? Or more second lien? Do you have any thoughts on that?

Yes, look, I think we're going to stay away from second lien in this portfolio. We're going to be cautious about stretch senior deals for us, as you can see in PFLT itself. We would prefer to have a lower risk, low reward portfolio, and maybe leverage a little bit higher, in the 1x to 1.5x zone similar to some competitors. Every once in a while, if we think we have a real opportunity or edge, we might consider doing a little more senior or unitranche financing. However, we will specifically avoid second lien in this portfolio.

Okay. I noticed that quarter-over-quarter, you guys have been reducing the leverage in the JV. I noticed that the return this quarter, at least what was paid out to the BDC, was relatively stable from last quarter, maybe up slightly. Is that the kind of return that we can expect going forward in terms of where the leverage is at on the JV and what return it is splitting out? Or do you have any other plans regarding the JV?

Yes, and I highlighted this in the script. Let me be clear: similar to PFLT, we’ve been waiting to see how the economy and our portfolio performed over the last number of quarters. One positive outcome is that our securitization, CLO financing in PFLT has been terrific, acting as a great way to finance these lower-risk assets. We will explore using this same financing strategy with PSSL, aiming to grow PSSL from approximately $400 million to around $550 million or maybe even $600 million utilizing this securitization-style financing that has worked so well for us in PFLT. So in terms of NII growth at PFLT and PSSL, we are hopeful that growing the portfolio and using securitization financing can play a significant role in that.

Got you. Finally, I'm very curious about the stock market, which has grown significantly this year. Do you see that as a potential meaningful driver for more middle-market acquisitions such as Cano Health? Or do you think that being in the middle market may not be as highly prized compared to acquisitions by special purpose acquisition companies? Any thoughts on that acquisition? And could it potentially be a driver for further exits in the portfolio?

Yes. We view the stock market as another form of an IPO. Stocks and IPOs that perform well were destined to do well anyway. In the case of Cano, it has been such a high-growth business, and the addressable market for what they do is vast, making an IPO very logical for the company given its growth trajectory. A comparable company is Oak Street Health, which trades in an $11 billion to $12 billion market capitalization. When you compare Cano to Oak Street and analyze revenues, EBITDA, members, and medical loss ratio, Cano aligns very favorably with Oak Street Health, which is a great company. Therefore, it's quite possible that Cano could trade in line with or better than Oak Street Health over time. We believe this is an attractive deal from the start, and there's substantial upside potential for Cano in this market.

Great. One more if I may. I think you mentioned this in your prepared remarks, but I didn't catch it. Do you know the percentage of your portfolio that has a LIBOR floor?

Yes, it was mentioned in our prepared remarks. The percentage is 86% with a LIBOR floor.

That is correct. Yes, the LIBOR floor is 1%, but about 86%, yes.

We take our next question from Mickey Schleien of Ladenburg.

Good morning, Art and Aviv. I just wanted to follow up quickly on the senior loan fund. I calculated a blended ROI taking into account the equity and debt investments of a little north of 9%. Are you satisfied with that level of return, or are you looking for something higher with more leverage on that balance sheet?

Hey, it's a great question, Mickey. Obviously, over the last few quarters, we've specifically waited to see how our portfolio performed along with the economy. This is why we are considering growing PSSL back up to a larger entity and utilizing securitization financing. Over time, we plan to target an 11% to 12% return on that vehicle.

That's a blended sort of ROI.

Yes, obviously piece of paper.

Okay. And Art, could you be a little more specific about the advantages of securitization versus the credit facility in that fund? Because I'm no expert like you guys, but I’m curious, what are the features that attracted you to that?

It's simply very efficient, low cost, and it's a kind of permanent financing—not entirely permanent, but long-term financing. There’s a structured box, and you don't need to negotiate with individual parties; there's no credit guys, which might cause sleepless nights. It's straightforward. If we have confidence in our underwriting— as we do—this box works for our portfolio's low-risk, low-reward deals. If you look at the equity return on this, granted the CLO in this case, the equities run by PFLT, we had something like a 20% return on the equity because of the advantageous underwriting and the underlying box.

That's a very solid number relative to what I'm seeing elsewhere.

Yes, the Triple C basket allows up to 17.5% in middle market, whereas we are hovering around 8%. Because our underwriting works, this is a very beneficial box for us.

So are the bucket paraphrases, and are you suggesting that it's just perhaps an easier piece of capital to manage from your perspective?

Well, that’s part of the overall mix as we analyze PSSL. We’d love to grow PSSL, and it could be part of that overall mix along with credit facilities and bonds occasionally. We believe in diversified financing tools. We've been actively observing the performance of our CLO since last September when it was set up, and, subsequently, COVID hit in March. Its performance has been very promising. So we view this positively and believe exploring this strategy with PSSL could align nicely.

Understand. In terms of the mechanics, I haven't done the math, but I imagine most of the senior loan funds' assets are in the borrowing base for the credit facility, right? How do you extract those assets and form the CLO, and what is the timing of all of that?

Yes, that’s a great question. We're starting to explore now but lack a firm answer. However, the banks involved in PSSL are our partners, and we plan to speak to them about partnering in growing PSSL, including securitization and a revised credit facility. All of this is in play, and we hope to finalize this in the next quarter or two.

Okay, so it sounds like it's sort of mid-next year timing to put it all together.

I hope for earlier, but it's prudent to set your expectations for mid-next year while we may have a shot at sooner.

Just a couple of housekeeping questions: Your cash on your balance sheet has built up; is that to make the principal payment on the CLO notes due next month?

We have an amortization payment on the Israeli bonds coming up next month, and that’s what the cash is for.

Perfect, CLO. Okay, so that will be paid in cash. If I'm not mistaken, last quarter you stated average EBITDA on the portfolio was 35 to 40, but I think you just said 20 to 30 this quarter. Maybe I misheard the previous numbers; where's the ballpark for the portfolios out there?

We are currently working on that piece, Mickey. The average I gave you last quarter was 35 to 40, while the median is more like 25.

We'll take our next question from Devin Ryan at JMP Securities.

Great. A few of our questions were asked, but let me just ask one here on non-accrual and credit. I'm curious how you think about the broader portfolio, especially if we experience another COVID-related disruption, and I know there’s been slight pressure with first lien loans to Marketplace Events. Has there been any dialogue with the sponsor about providing more support?

Thank you, Devin, and nice to meet you. I'm looking forward to spending time with you as you assume the BDC role. Marketplace Events is finalizing its restructuring as we speak. Hopefully, by next quarter—I'm quite sure—that restructuring will be completed. The lenders will be assuming control of the company, injecting capital to help it navigate through to the other side once events start to return. It seems evident that events will return, and we see great potential in that company and area. PRA, another event planning company, is also in restructuring talks currently. Again, we expect them to come off non-accrual next quarter as it looks like sponsors have plans to inject equity support.

It appears there are no further questions at this time. Mr. Penn, I would like to turn the call back to you for any additional or closing remarks.

I just want to thank everybody for being on the call today. We appreciate it. Given the late reporting period this quarter, there will be a relatively short period until early February when we have our next quarter's numbers. We look forward to speaking with everyone then. Thank you very much.

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