PennantPark Floating Rate Capital Ltd. Q4 FY2021 Earnings Call

Good morning and welcome to the PennantPark Floating Rate Capital's Fourth Fiscal Quarter 2021 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 2021 earnings conference call. I'm joined today by Richard Cheung, our Chief Financial Officer. Richard, 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 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 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, Richard. 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, the financials and then open it up for Q&A. Our core net investment income grew to $0.28 per share, which excludes a one-time expense of $2.9 million in connection with the amendment of our credit facility. Our credit quality generally remains solid. We are poised to significantly grow NII through a three-pronged strategy which includes: one, growing assets on the balance sheet of PFLT as we move towards our target leverage ratio of 1.5 times debt to equity from 1.3 times; number two, growing our PSSL JV with Kemper to about $730 million of assets from approximately $550 million; and 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. We intend to invest another $42 million over time in order to bring PFLT's investment in PSSL to approximately $243 million. 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. Our returns on these equity co-investments have been excellent over time. Overall, for our platform, from inception through September 30, our $246 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 3 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. During the September quarter, PFLT had new originations of $48 million and PSSL had new originations of $77 million far outpacing the repayment activity. As a result, the investment portfolio of PFLT increased by approximately $46 million to $1.08 billion from $1.04 billion. PSSL's investment portfolio also grew this quarter from $565 million to $565 million from $530 million, an increase of $35 million. We continue to be busy. Since September 30th, PFLT has had new funded investments net of sales and repayments of $82 million. PSSL has had new funded investments net of sales and repayments of $23 million. We are focused on the core middle market, which we generally define as companies with between $10 million and $50 million 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 diligence and the time frame 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 companies. 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&P, loans to companies with less than $50 million of EBITDA have a lower default rate and a higher recovery rate than those loans to companies with higher EBITDA. Our portfolio performance remains strong. As of June 30th, average debt-to-EBITDA in the portfolio was 4.3 times and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.2 times. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. As of September 30th, we had only two non-accruals out of 115 different names in PFLT and PSSL. This represents only 2.7% of the portfolio at cost and 2.6% at market value. For the quarter ended September 30th, the decline in the value of DBI Holding was the largest driver of the decline in NAV and represented a negative impact of $0.29 per share. This was somewhat offset by increases in the valuations of lash OpCo, marketplace events and SFP Holding. Since quarter end, DBI has continued to underperform and the company has decided to pursue a partial sale and liquidation of the business. It is unclear at this point how this will play out. In the worst-case scenario, if PFLT and PSSL have no recovery, NAV would be negatively impacted by $0.28 per share. From an NII perspective, the impact of DBI to NII is expected to be $0.03 per share per quarter. The portfolio is highly diversified with 110 companies in 45 different industries. Our credit quality since inception over 10 years ago has been excellent. Out of 418 companies in which we have invested since inception we have experienced only 14 non-accruals. Since inception, PFLT has invested over $4.4 billion at an average yield of 8%. This compares to a loss ratio of only 8 basis points annually. We are one of the few middle-market direct lenders who were 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 investing at that time. During that recession the weighted average EBITDA of our underlying portfolio companies declined by 7.2% at the bottom of that recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%. Based on the tracking of EBITDA of our underlying portfolio 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, where we have a meaningful domain expertise. The outlook for new loans is attractive. We are as busy as we have ever been in 14 years in business, reviewing and doing new deals. With our experienced and 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. Let me now turn the call over to Richard, our CFO, to take us through the financial results in more detail.

Thank you, Art. For the quarter ended September 30, core net investment income was $0.28 per share, which excludes a one-time expense of $2.9 million in connection with the amendment to the credit facility. Looking at some of the expense categories. Management fees and performance-based incentive fee totaled about $3.3 million. Taxes, general and administrative expenses totaled about $450,000 and interest expense totaled about $8.5 million, which includes the credit facility amendment expense. During the quarter ended September 30, net change in unrealized appreciation on investments was a loss of $7.5 million or $0.19 per share. Net realized gains were about $2.5 million or $0.06 per share and changes in the value of our credit facility and notes decreased NAV by $0.01 per share. GAAP investment income was lower than a dividend by $0.05 per share. Consequently, GAAP NAV went from $12.81 to $12.62 per share. Adjusted NAV, excluding the mark-to-market of our liabilities was $12.43 per share, down from $12.62 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 on 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 the investments. With ample liquidity and prudently levered, our GAAP debt-to-equity ratio was 1.3 times, while GAAP net debt to equity after subtracting cash was 1.2 times. Regulatory debt-to-equity ratio was 1.4 times and our regulatory net debt-to-equity ratio after subtracting cash was 1.3 times. With regard to leverage, we have been targeting a debt-to-equity ratio of up to 1.5 times. We have a strong capital structure with diversified funding sources and no near-term maturities. We have a $300 million revolving credit facility maturing in 2026 with $290 million drawn as of September 30. $118 million of unsecured senior notes maturing in 2023, $228 million of asset-backed debt associated with PennantPark CL1, due 2031 and $100 million of unsecured senior notes maturing in 2026. Subsequent to September 30, PFLT issued an additional $85 million of 4.25% 2026 unsecured notes bringing the total principal to $185 million. The add-on notes were issued at a premium resulting in a yield of 3.875%. The proceeds from this note issuance provide additional capital for investments. Our portfolio remains highly diversified with 110 companies across 45 different industries. 86% is invested in first lien senior secured debt, including 13% in PSSL, 1% in second lien debt, and 13% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 7.4%. 99% of the portfolio's holding rate and 81% of the portfolio has a LIBOR floor. The average LIBOR floor is 1%. Now let me turn the call back to Art.

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.

Thank you. And our first question today comes from Paul Johnson of KWB – KBW, I'm sorry.

Good morning, guys. Thanks for taking my questions. Sounds like the pipeline is pretty strong, you got some pretty strong growth activity here quarter-to-date is the calendar fourth quarter. I'm just wondering, given the investment opportunities that you guys are looking at, I mean, are you – you're getting up close to the leverage range. Are you compelled to be given, what you're looking at do you have an idea in mind where you would like to be operating at in terms of your leverage range on the low-end versus the high end?

Yeah. Thanks, Paul, and good morning. Yeah. I think we're targeting kind of 1.5 – the zone of 1.5 times for PFLT. That's kind of where we're targeting. Of course, PSSL is a joint venture, kind of side-by-side, and that vehicle we hope and think can over time grow to be over $700 million, $750 million vehicle, which we got a boost from the CLO financing we did there a little while back, and we'll continue to grow that platform. And yes, you're right we're at 1.3. I think 1.5 zone, we kind of top out PFLT.

Great. Appreciate that. And then one thing just on the sort of, I guess, the change quarter-over-quarter in your equity investments. I was wondering, if there was anything particular going on there, if there's any sort of restructuring or new equity investments? It looks like at least on a cost basis, they went-up pretty – quite a bit quarter-over-quarter, but I'm wondering, what's going on there?

Yes, I believe part of that is likely attributed to PSSL and its growth, which is probably the main factor. Aside from that, we continue to engage in deals where we see strong potential for upside. We are selectively and carefully pursuing these equity co-investments that have been successful for us over the past 14 years. We don’t accept every opportunity and have turned down many, but we do proceed with the ones we find particularly appealing. Therefore, I think the most significant change is the ongoing investment in PSSL as we work to expand that initiative.

Thanks for that. My final question is about your investment in DBI. Could you provide more details about that business? I'm also interested in whether there is any overlap with the joint venture.

Yes. DBI is involved in both PFLT and the joint venture. We discussed its implications on a consolidated basis between both PFLT and PSSL. The company provides labor services for municipalities and states, focusing on tasks such as managing vegetation, lawn care, and laboratory management. As you may have read, with a portfolio of over 100 names, it’s likely that at least one will face challenges. Most of their workforce consists of unskilled labor, which has been difficult to source, and hiring such labor has become more expensive. Additionally, the company has fixed-price contracts with states and cities, leading to a mismatch between these contracts and the requirements of the unskilled labor market. This has been the primary reason for its underperformance. They are currently considering a partial sale and partial liquidation, but the outcome is uncertain. We provided statistics on the potential worst-case scenario, which could vary. However, we have a diverse range of equity co-investments in the portfolio, some of which showed improvement. In the last quarter, which ended on September 30th, DBI negatively affected earnings by $0.29 per share, but this was partially balanced by stronger performances from other co-investments like lash, marketplace events, and SFP. We have a varied portfolio of these co-investments, with some doing well while others, like DBI, are underperforming. We believe this issue is not indicative of our entire portfolio but rather an isolated case. The majority of our investments maintain EBITDA margins of 25% to 30%, enabling them to raise prices to customers in order to cover costs effectively.

Got it. Appreciate it. Thanks for the color. Very helpful detail. Those were all my questions.

Thanks.

Our next question comes from Mickey Schleien of Ladenburg.

Yes, good morning everyone. Art, in your prepared remarks, you mentioned a lot of the advantages of investing in the lower middle market and I certainly agree. My question is given how intense the competition is higher up in the middle market with so much private debt and private equity capital available. Are you seeing any signs of that trickling down into the middle market and the lower middle market? And are you seeing competitors perhaps idiosyncratically behaving erratically or irrationally?

Yes, it's a good question. Thankfully, we don't see much of that moving down into the core middle market. Some of these larger firms have raised substantial capital and are actively investing it, often offering covenant light and low yield with shorter diligence processes. We generally define the core middle market as companies below $50 million. Occasionally, a company with around $40 million in EBITDA might get picked up by a bigger player, and we accept that. However, below $40 million, we’re not observing this trend. While that could change and we remain watchful, currently we aren’t seeing it in that segment. We focus on areas where we can add value, as shown by our track record, which we'll discuss further in the PNNT call. Over the past six years, we've successfully engaged with companies generating $10 million to $20 million in EBITDA. These sponsors have invested considerable equity into these businesses, providing us with confidence in capital preservation. There's a solid growth strategy to increase the EBITDA of these companies to $30 million, $40 million, $50 million, and beyond, allowing our debt capital to expand alongside them. We have a prime position as incumbents with less competition in debt financing. Occasionally, we co-invest in equity, allowing us to benefit from the growth our debt facilitates. These deals represent where we can deliver the most value currently, as our capital is not commoditized, giving us a strategic advantage for the long term along with potential upside. That’s the typical deal structure for us across our platform. Some of these companies eventually grow to generate $40 million, $50 million, or even $100 million in EBITDA, which is excellent. Sometimes they outgrow our debt assistance, and we retain the equity, which can be quite valuable. This is where we see our highest value-add today.

Right. Thanks for that, Art. And to follow-up, given the size of those private funds, do you think there's effectively a barrier of entry into the lower middle market where the average deal size just doesn't move the needle for them? And even though the terms may be interesting, it's just not something that they're going to put a lot of time. And does that benefit you?

Yeah. I think that's fair. When you're in the AUM growth business and it's about AUM growth and you're looking at the amount of labor intensity you need to put against the deal versus how much capital you can deploy I would agree with you. And a long time ago, I was at a big firm. I know how sometimes they think below a certain bite size it just doesn't make sense for the model.

I understand. My last question, Art, is just a little more philosophical thinking about next year relative to what we've had the last couple of years. This year in particular there's been a lot of tailwinds in the sector apart maybe from high levels of repayments and prepayments. But next year economic growth might decelerate the Fed and might start raising rates. Certainly, defaults probably can't go any lower. They've been historically very low and we have an election. So it could be messy. When you think of those issues, how are you considering the right-hand side of your balance sheet both at, I guess, at both of your funds or all of your funds in terms of do you want to take some money off the table and keep leverage perhaps below your long-term targets next year and see how things work out?

You're correct. In 2022, we faced various challenges such as supply chain issues, labor shortages, and inflation. To address these challenges, we prioritize underwriting companies that can adapt and have enough flexibility to raise prices as costs increase. This requires careful evaluation in the current environment. We believe we are well-positioned, with an EBITDA to interest ratio of around three to 3.2 times in our portfolio, providing a good cushion to manage rising interest rates. Regarding leverage for PFLT specifically, we are targeting 1.5 times. It's important to note that these same assets could also be leveraged up to three or four times in S&P's CLO department, which has proven to be resilient during economic downturns. We are confident in our 1.5 times target for PFLT since we consider the underlying assets to be among the lowest risk in the BDC sector. There is also the option to increase leverage if desired while maintaining confidence in our capital structures. Additionally, our target ratio is lower for Pennant due to different underlying assets. We've recently issued unsecured bonds as part of our strategy and will continue to use diverse financing sources to manage risk effectively.

Thank you for that, Art. That's very helpful. And I look forward to talking to you later today. Thanks.

Thanks.

The next question comes from Devin Ryan of JMP Securities.

Hi. Good morning. This is Kevin Fultz on for Devin. First question, over the past few quarters you've talked about the three-pronged approach to continue growing operating earnings. And clearly, you've made progress this year in growing NII. This quarter core NII was just shy of covering the dividend. Could you talk about when you expect net investment income to cover the dividend going forward? Thanks.

We believe that as we continue to execute our plan, it is difficult to specify an exact date, as it relies on deal flow, repayments, the rotation of equity, and how quickly we can ramp PSSL. We hope that sometime in 2022, we can safely cover this dividend.

Okay. Makes sense. And then could you provide an update on the current amount of spillover income?

The current spillover is $0.22 per share. If distribution remains stable, we should be able to cover that over the next three quarters.

Okay. And that's as of September 30th, 2021?

Yes, correct. Yes.

Great. Thank you. That's it for me, and thank you for taking my questions.

Kevin, thank you. Appreciate it.

As there are no further questions, I would like to hand the call back to Art for any additional or closing remarks.

Thanks everybody for listening in and giving us your time and attention. Our next quarterly call will be in early February. In the meantime, wishing everybody a terrific Thanksgiving, a terrific holiday season and a season filled with health. Speak to you soon.

Ladies and gentlemen, that concludes today's conference call. We thank you for your participation. You may now disconnect.