PennantPark Floating Rate Capital Ltd. Q1 FY2021 Earnings Call

Good morning, and welcome to the PennantPark Floating Rate Capital's First Fiscal Quarter 2021 Earnings Conference Call. Today's conference is being recorded. 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 First Fiscal Quarter 2021 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 that includes 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 a 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 customer 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 filing 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 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 performed in the quarter ending December 31, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, and then open it up to questions. Despite the challenging economic conditions caused by the pandemic, we are pleased with our performance this past quarter. We saw a substantial increase in NAV during the quarter, with adjusted NAV rising 4.3% from $11.81 to $12.32 as our portfolio continued to improve. Several portfolio companies have seen significant appreciation in value, and we are benefiting from the K-shaped recovery, which is reinforcing our NAV. Over time, transitioning that equity into debt instruments should help grow PFLT's income. We will highlight those companies in a few minutes. As part of our business model, alongside our debt investments, we selectively choose to co-invest in equity alongside the financial sponsor. Our returns on these equity co-investments have been excellent over time. Overall, from inception through December 31, our $217 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.9 times. In a landscape where investors are keen to understand differentiation among middle-market lenders, our long-term returns on our equity co-investment program clearly set us apart. Additionally, in late December, we priced a CLO financing in our PSSL joint venture, which closed in late January. We have been pleased with the stable performance of PFLT's long-term low-cost securitization CLO financing during COVID. This financing is well matched to support our senior debt positions, which we believe are among the lowest risk in the industry. Completing this CLO financing for PSSL enables us to efficiently grow the venture, which should generate additional income for PFLT. The combination of potential income growth from equity rotation, a larger and more efficiently financed PSSL, and a more optimized PFLT balance sheet should help increase the company's net investment income relative to its dividend over time. Together with strong portfolio performance during COVID and our $0.22 spillover as of September 30, we have decided to maintain our dividend steady at this time. While we did not anticipate a global pandemic, we have been preparing for a potential recession for some time. Before the COVID-19 crisis, we proactively positioned the portfolio as defensively as possible. Since inception, we have maintained a portfolio that is among the lowest risk in the direct lending industry. As of December 31, the average debt-to-EBITDA in the portfolio was 4 times, and the average interest coverage ratio—the amount by which cash income exceeds cash interest expense—was 2.9 times. This provides a strong cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. We have only two nonaccruals out of 105 different names in PFLT and PSSL, representing only 2.3% of the portfolio cost and 1.9% at market value. We have largely avoided sectors that have been severely impacted by the pandemic, such as retail, restaurants, health clubs, apparel, and airlines. PFLT also has no exposure to oil and gas. The portfolio is well diversified with 100 companies across 42 different industries. Our credit quality has remained excellent since inception over nine years ago, with only 13 nonaccruals out of 387 companies in which we have invested. Since inception, PFLT has invested over $3.7 billion at an average yield of 8.1%, compared to an annualized realized loss ratio of just 10 basis points. Including both realized and unrealized losses, the underlying loss ratio is only 12 basis points annually. We are one of the few middle-market direct lenders that were operational before the global financial crisis and have maintained a strong underwriting track record throughout. Although PFLT did not exist back then, the PennantPark organization was investing during that time. During that recession, the weighted average EBITDA of our underlying portfolio companies decreased by 7.2% at the bottom of the recession, compared to an average decline of 42% in the Bloomberg North America High Yield Index. We take pride in this strong performance during the prior recession. So far, based on our analysis of EBITDA for our underlying companies during COVID, we anticipate the decline to be significantly less than what we experienced during the global financial crisis. Looking ahead to 2021, our current analysis suggests that most of the companies in our portfolio are well-positioned to perform favorably in the upcoming quarters. Many of our portfolio companies operate in sectors such as government services, defense, healthcare, technology, software, business services, and select consumer companies that have been less affected by COVID and where we possess significant domain expertise. We see a K-shaped recovery occurring, with certain companies and industries becoming significant beneficiaries of the current environment. We are pleased to have meaningful equity investments in three such companies, which can greatly impact both NAV and net investment income over time. I would like to highlight these three companies: Cano, Walker Edison, and By Light. Cano Health is a national leader in primary healthcare, innovating to deliver high-quality services at a reasonable cost to a large population. Our equity position had a cost of $431,000 and a market value of $9.1 million as of December 31. Cano has been rapidly growing, with revenues nearly quintupling and EBITDA more than tripling over the past three years. We believe there is a significant market opportunity for Cano in the coming years, especially with the Medicare Advantage program. During the quarter ending December 31, we received $200,000 in cash as a return of capital. The merger with Jaws Acquisition is set to close at the end of March or early April, at which point we will receive another $800,000 and own 825,274 shares of Cano Health in a limited partnership controlled by a financial sponsor, who will hold 20% of the exit proceeds. Due to this lockup, the independent valuation firm applied a 7% illiquidity discount to the traded value on December 31 for valuation purposes. Walker Edison is a leading e-commerce platform specializing in selling furniture exclusively online through top e-commerce companies. Since our investment in 2018, their sales have more than tripled, and EBITDA has increased almost fourfold. Our position in Walker Edison had a cost of $1.4 million and a fair market value of $11.1 million as of December 31. By Light is a prominent provider of software, hardware, and engineering solutions addressing national security challenges, including modeling and simulation, cybersecurity, and global defense networks. Since we first invested nearly four years ago, their sales have grown 1.5 times, and EBITDA has more than doubled. Our position has a cost of $2.2 million and a fair market value of $10.8 million as of December 31. All three of these companies are gaining financial traction in this environment, and our NAV is likely to be strengthened by these significant equity investments as we continue to build momentum. Over time, we aim to liquidate these positions and reinvest the proceeds into debt instruments to enhance income at PFLT. We were active in making new loans this past quarter, and I'll highlight some of those. We purchased $15 million of the first-lien term loan of the Aegis Technologies Group, a government contractor providing unique solutions in space superiority, directed energy, and missile defense, with Arlington Capital Partners as the sponsor. We also acquired $9.5 million of the first-lien term loan and co-invested $504,000 of common equity in Applied Technical Services, a provider of nondestructive testing, calibration lab, and consulting engineering services, sponsored by ISC Investment Partners. Hancock Claims Consultants, which offers leading insurance claims services in the residential roofing market, saw us purchase $6 million of their term loan and $450,000 of equity, with Century Equity Partners as the sponsor. Rancho Health, a primary care provider in Southern California focusing on value-based primary care, received $3.7 million of our first-lien term loan along with a co-investment of $1.1 million in common equity, sponsored by LightBay Capital. We invested $7.5 million of the first-lien term loan and $642,000 of common equity in Sigma Defense Systems, a leading IT services provider and systems integrator of satellite communication equipment for mission-critical airborne surveillance programs, sponsored by Sagewind Capital. The outlook for new loans appears promising. We believe that middle-market lending is an enduring business. The upcoming vintage of loans is likely to be the most attractive we have seen since the period from 2009 to 2012, characterized by lower leverage levels, a higher equity cushion, higher yields, and tighter protections, including covenants. After navigating approximately five years of a late-cycle market in middle-market lending, it is refreshing to have appealing risk-reward opportunities available to us. Let me now turn the call over to Aviv, our CFO, to discuss the financial results in more detail.

Thank you, Art. For the quarter ended December 31, net income was $0.26 per share. Looking at some of the expense categories, management fees totaled about $4.5 million. Taxes, general and administrative expenses totaled about $800,000, and interest expense totaled $5.3 million. During the quarter ended December 31, net unrealized appreciation on investment was $23 million or $0.58 per share. Net realized losses were about $2.7 million or $0.07 per share. Net unrealized depreciation on our co-facility and notes was $0.10 per share. Net investment income was lower than the dividend by $0.02 per share. Consequently, GAAP NAV went from $12.31 to $12.70 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.32 per share, up 4.3% from $11.81 per share. Our entire portfolio, our credit facility and notes are marked to market by our Board of Directors each quarter using the exit price provided by an independent valuation firm, exchanges or independent broker-dealer folks 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 the investments. Our spillover as of September 30 was $0.22 per share. We have ample liquidity and are prudently levered. Our GAAP debt-to-equity ratio was 1.2x, down from 1.4x last quarter. While GAAP net debt-to-equity after subtracting cash was 1.1x, down from 1.3x last quarter. Regulatory debt-to-equity ratio was 1.3x, down from 1.5x last quarter. And our regulatory net debt-to-equity ratio after subtracting cash was 1.25, down from 1.4x the last quarter. With regard to leverage, we have been targeting a debt-to-equity ratio of 1.4x to 1.6x. Our net of cash regulatory asset coverage ratio of 1.2x was well below the low end of our range of this past quarter. We had ample liquidity to fund we've overdrawn, and we're in compliance with all of our facilities at December 31. We have regularly available borrowing capacity and cash liquidity to support our commitments. We have a strong capital structure with diversified funding sources and no near-term maturity. We have $400 million revolving credit facility maturing in 2023, with a syndicate of 11 banks with $257 million drawn as of December 31, $118 million of unsecured senior security notes maturing 2023, and $228 million of asset-backed debt associated with one of our CLO I due 2031. Our portfolio remains highly diversified with 100 companies across 42 different industries. 87% is invested in first-lien senior secured debt, including 12% in PSSL, 3% in second-lien debt, and 10% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 7.5%. 98% of the portfolio is floating rate and 86% 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. We try to find less risky middle-market companies that have high free cash flow conversion. We capture our 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.

We can now take our first question from Kevin Fultz with JMP Securities.

First, sort of looking at nonaccruals. They all stop at second lien and then PRA events first lien renewed from nonaccrual during the quarter. Can you provide some color around why those investments are renewed for nonaccrual? What amendments looked like?

Sure. Thanks, Kevin. PRA, the sponsor, injected more equity. So we agreed, as part of that deal, to a formula where the sponsor put in more equity and we put them back on nonaccrual. And that company is moving forward with a much better liquidity position. MSpark or MailSouth went through a full restructuring, where our original second-lien was converted to equity. We and the other second-lien holders put in additional second-lien and we have an agreement with the first-lien player to give the company a couple of years of room to rebound. The company has done quite nicely since the restructuring and seems to be rebounding quite nicely.

Okay. I appreciate that color. And then now that PSSL has completed the CLO financing, can you discuss the level of growth we can expect and enjoy moving forward?

Sure. So PSSL can, with leverage, get up to about $550 million of total assets or so. So that's something we'll look to achieve thoughtfully and carefully in the coming quarters.

Okay. And then lastly, just touching on prepayments. What visibility do you have around that kind of prepayment? And then just the level of prepayments quarter-to-date so far?

Yes. Yes, that's a good question. What level of transparency we have around prepayments. Usually, we have pretty good transparency. We typically get enough in financial statements. We're typically talking to the management and sponsor at all times. So far, our prepayments have been somewhat muted this quarter. However, with the portfolio performing so well, which ultimately is, for us, the most important thing, we could have more prepayments. So I'd say we're going back into a more normalized environment. I mean, normalized environment for us is where the portfolio rotates 25% to 33% a year on the debt side, and we need to replace it and, as we said in the prepared remarks, to potentially grow. So I'd say we're back to a more normalized environment.

We'll go ahead and take our next question from Ryan Lynch with KBW.

Art, you mentioned that the outlook for new loans is quite appealing due to lower leverage levels, increased protection, and some higher yields. However, I'm curious if you've noticed a decline in the quality and benefits of those deals, returning to pre-COVID levels. We've observed that in the liquid markets, terms and structures have mostly reverted to pre-COVID conditions. In the market you're focused on, are you seeing a similar trend? If that’s the case, how long do you anticipate before we continue to see better deals compared to pre-COVID levels?

That's a terrific question, Ryan. And first, it's a definitional question, which is what market do we play in and where do we play and where do some of our peers play in. We focus on what we call the core middle market, which includes companies with $15 million to $50 million of EBITDA. This is below the fray of competing with the broadly syndicated loan market or the high-yield market. Many of our very large peers who manage tens and hundreds of billions of assets really do compete on a day-to-day basis with the broadly syndicated loan market. They are in the business of writing big checks to big companies. And we're going to have to make quick decisions. Deal flow is quick. They're only getting financial statements every 3 months. It's covenant-light or covenant-wide. There is a lot of velocity in that space because there's less of an opportunity for due diligence. We compete in the $15 million to $50 million space, which takes longer to gestate. We are conducting extensive due diligence and negotiating multiple covenants. It's a much more labor-intensive and slower process. As part of this, we also get these equity co-investments, which we've had a very nice track record on with the 2.9x MOIC track record. So it's a different world. It's a slower-moving world. As a result, it's taking longer for the bounce back. If we were competing with the broadly syndicated loan market or the high-yield market, which is back to where it was pre-COVID, we basically have to move to that level. In our world, it has bounced back somewhat since the bottom of COVID but certainly nowhere all the way back. We kind of like where we're positioned. We like this $15 million to $50 million core middle market, and we think we can get really attractive risk-adjusted returns. I think we've come through COVID, and it has kind of improved then through COVID. We've had very minimal defaults and our equity co-invested that with a lot of return. If you look at our senior private credit vehicle, which is a private version of PFLT that had a net return of 18% for 2020, which is remarkable when you consider it closed in 2020. We had an 18% net return for a vehicle that looks a lot like PFLT. And our credit ops vehicle, which looks a lot like PNNT, had a 28% to 29% net return for 2020. So a combination of low defaults and the equity co-invest returns really positions us well during COVID.

Okay. That's helpful against the color on the market. I know in the past, prior to COVID, you, as well as many other direct lenders, talked about late cycle investing and, of course, PFLT targets that in general as far as being high up the capital structure and more recessions with the businesses. I'm just wondering, though, now that we're coming out of a downturn or a pandemic, do you intend or do you have any appetite to shift the investment focus of PFLT at all? Maybe taking on more of this since we just ran through a down scenario? Or is it going to be kind of steady as you always have invested in your target markets, whether that's where you are on the capital structure or as far as industry exposure?

Yes. Look, PFLT has always been positioned from day one as what we hope and think has been your grandmother's BDC with a lower risk, lower reward, lower expense structure. Our yields are among the lowest in the industry. Our leverage of 4x is among the lowest in the industry. Our expenses are among the lowest in the industry. For PFLT, we're not intending to veer off that. I think one of our key focuses going forward, though, is we have these 5 key sectors where we've developed really meaningful domain expertise where we can be among the smartest people in the room. The deals come in, and I think that's where we're digging deeper. Of these sectors, we include government services, defense, health care, technology and software, business services and consumer. When a deal comes in, they know the right questions to ask. We're really prepared. And in those areas where we think we have the domain expertise, we're going to play.

Okay. And then I just had one last one. In January, PennantPark as a platform, you closed PennantPark Credit Opportunities Fund III. I'm just curious, is the investment strategy of that fund similar to PFLT? Or is it more similar to PNNT? And is there any ability to co-invest with PFLT to co-invest across that fund? Or does that have any sort of impact on PNNT or PennantPark as a platform's ability to better the speed? Can you just talk a little bit about that? That would be helpful.

Well, now we have a growing private business. Overall, PennantPark, we have 2 separate strategies. We have opportunistic, which is a blend of higher-yielding first-lien, second-lien as well as equity co-invest. And we have senior debt. It's basically senior distressed as well as equity co-invest. PFLT is a senior debt vehicle, and we have private vehicles that look a lot like PFLT but are private. As I said, those vehicles had an 18% net return in 2020 due to very minimal nonaccruals and the strong equity co-invest track record. The other side of the equation is our opportunistic strategy, which looks a lot like PNNT, excluding the energy. As you know, with PNNT, we have concerns regarding energy, which has been a challenge for PNNT in our credit ops business, that looks a lot like PNNT without the energy. It's that focus and that's the fund that we closed. Again, it had a 29% net return in 2020 due to very minimal defaults in these equity co-investments, which were performing well. So, PennantPark at large, we operate two strategies: opportunistic and senior debt, and our BDCs mimic that. Although we hope to get out of the energy sector at some point, and we think we're making good progress. We will talk about that later.

We'll go ahead and take our next question from Mickey Schleien with Ladenburg.

Art, I wanted to ask about a little bit of a query on the pandemic. When we think about the pace of vaccinations and the virus's mutations, it certainly looks like the pandemic will go on longer than we had hoped. And that will obviously continue to stress some companies and some industries like event planning, where I see that you injected additional capital in one of your borrowers. My question is, how significant do you think the need is to continue to inject capital in these specific situations? And how willing are your private equity partners to write additional checks to support those borrowers and get them through to the other side?

That's a great question. It's one we've rapidly worked with some of these companies. I mean, I think, first, all of these companies have done a really good job maintaining liquidity, and they're all in a very liquid position. We feel good about their liquidity. However long this takes, our underwriting case does not assume a bounce back in the spring or the summer. Our underwriting case assumes a bounce back later in 2021 and 2022. We weren't counting on any kind of bounce back in the spring or summer. We may or may not have any bounce back in the spring, summer, but we do not underwrite that way. We have made sure all these companies are very liquid, which they are. So really good management teams. These are what you would call good companies, which just happened to now be hit by COVID but have solid management teams who've done the right things, whether by the management teams or the sponsors. We feel they are as well positioned as they can be to deal with an elongated vaccination schedule, which we may be facing.

Looking at the portfolios in the fourth quarter, the fourth calendar quarter was strong for middle-market M&A. However, I noticed that both PFLT on balance sheet and the senior loan funds performance both shrank. Fee income was not particularly high for the company. Could you just discuss the backdrop for that trend in terms of the market opportunity and their pipeline? And were prepayments higher than you had expected? Just some background on that would be helpful.

Yes, that's a great question. A significant amount of the prepayments occurred earlier in the quarter, particularly with Cano; we had a large investment in Health that was repaid due to a broadly syndicated loan arranged by a major investment bank. Towards the end of the quarter, we became very active, closing several deals between Christmas and New Year's. Those deals were quite busy, and we feel we are getting back up to speed. In this core middle market, these transactions are more customized and require more time for due diligence. We believe the overall risk-adjusted return, including the co-invest, is very appealing and in some cases better. However, getting things moving takes time. Our teams are actively evaluating numerous deals, and we've learned that sometimes it's best not to rush the process. We're encouraged by this increase, as it involves a significant number of solid companies. Still, we want to be careful and methodical about what we add to these portfolios. We will proceed with the same prudent approach we always have. We are not opposed to ramping up; it's mainly a matter of timing and making sure the deals we choose for these funds are robust.

Yes, I understand. Just a couple more sort of housekeeping questions. Was the marketplace events restructuring the main driver of the realized loss? Or was there something else causing that result?

Yes. That, as well as MailSouth, were the two events where you realize those gains or losses when there are losses, in this case, when there's a restructuring.

Okay. And lastly, administrative expenses continue to decline. Was that due to some sort of change in the agreement with the adviser? Or was it due to the relative size of PFLT to the overall platform or something else?

The main driver is our growing private funds business. When we do have a finance and ops team with fixed G&A, that gets allocated pro-rata around our platform. To the extent our private funds business is growing, which it is, and with future returns, it will continue to grow, it really helps the BDCs and lowers the G&A.

Okay, so it was a relative size. That's it for me.

Well, it appears there are no further questions. I'd like to turn the conference back to the speakers for any additional or closing remarks.

Thanks, everybody, for your interest in PFLT. We look forward to speaking with you in early May as we review the March results. Thank you. Stay safe and healthy. Have a good day.

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