PennantPark Floating Rate Capital Ltd. Q1 FY2022 Earnings Call

Good morning and welcome to the PennantPark Floating Rate Capital's First Fiscal Quarter 2022 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 after 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 first fiscal quarter 2022 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. Over to you.

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 December 31, how the portfolios are positioned for the upcoming quarters, our capital structure and liquidity, the financials, and then open it up for Q&A. Our net investment income grew to $0.33 per share, which includes $0.05 of other non-recurring income. Our credit quality remains solid. We're pleased that we've grown NII through growing the assets on the balance sheet at PFLT, as well as that of our PSSL joint venture. Now that we have reached the zone of our target debt equity ratio at PFLT, we remain focused on two additional prongs of our strategy to grow NII. Number one, growing our PSSL JV with Kemper to enhance overall ROE at PFLT, and number two, rotating the equity value in our portfolio that has come from our strong equity co-investment program into cash-paying debt instruments. With regard to the PSSL joint venture, with the CLO financing we completed earlier this year, as well as additional capital contributions from PFLT and Kemper, the JV will continue to grow. The capital contributions from PFLT are targeted to generate a 10% to 12% return. We're on a path to grow PSSL to over $700 million in the current quarter. We have started discussions with Kemper to increase the JV to have approximately $1 billion of assets over time. We believe that the increase in scale and the attractive ROE will enhance PFLT's earnings and momentum. 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 December 31, our $297 million of equity co-investments have generated an IRR of 29% and a multiple on invested capital of 2.9 times. In a world where investors may want to understand differentiation among middle market lenders, our long-term returns on our equity co-investment program are a clear differentiator. We have implemented a significant portion of the NII growth strategy to date. The investment portfolio of PFLT increased by approximately $100 million in the quarter to $1.18 billion from $1.08 billion. PSSL's investment portfolio also grew this quarter from $642 million to $565 million, an increase of $77 million. We're focused on the core middle market, which we generally define as companies with between $10 million and $50 million of EBITDA. The target market, where we think we add the most value and where we get the strongest package of risk return, is in the $10 million to $30 million of EBITDA range. We like the core middle market because it is below the threshold and does not compete with a broadly syndicated loan or high yield markets unlike the upper middle market. As such, we do not compete with markets where leverage is higher, equity cushions lower, and covenants are light or non-existent. According to Lincoln International, the covenant-light share of direct lending loans increased from 20% in Q3 2021 to 35% in Q4, a 15% increase in just one quarter. We believe that this was driven primarily by the growth of the mega multi-billion dollar direct loans done by the largest direct lenders who compete heavily amongst themselves, as well as in the broadly syndicated loan market. Less covenant protection may ultimately have important ramifications down the road to outcomes. Virtually all of our loans in the core middle market have meaningful covenant packages which protect lenders. According to S&P, loans to companies with less than $50 million EBITDA have a lower default rate and higher recovery rate than those with higher EBITDA. We believe that the meaningful covenant protections of the core middle market have been an important part of this differentiated performance. Our portfolio performance remains strong. As of December 31, average debt EBITDA in the portfolio was 4.6 times and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense was 3.3 times. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. As of December 31, we had only three non-accruals out of 120 different names in PFLT and PSSL. This represents only 2.9% of the portfolio at cost and 2.5% at market value. The portfolio is highly diversified with 115 companies and 46 different industries. Our credit quality since inception over 10 years ago has been excellent. Out of 434 companies in which we have invested since inception, we have experienced only 15 non-accruals. Since inception, PFLT has invested over $4.7 billion at an average yield of 8%. This compares to a loss ratio of only seven basis points annually. Many of our portfolio companies are in industries such as government services, healthcare technology, software, business services, and select consumer companies where we have meaningful domain expertise. The outlook for new loans is attractive. We have been as busy as we have ever been in 15 years in the business, reviewing and doing new deals. With our experienced, talented, and growing team, our wide funnels are 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 December 31, net investment income was $0.33 per share, including $0.05 per share of other income. Looking at some of the expense categories, management fees and performance-based incentive fees totaled about $6.1 million. Taxes, general and administrative expenses totaled about $900,000. Interest expense totaled about $6.6 million. In the quarter ended December 31, the net change in realized appreciation on investments, net of any associated tax provision, was a loss of $5 million, a $0.13 per share. Net realized gains were about $3.1 million or $0.08 per share, and changes in the value of our credit facility notes increased NAV by $0.09 per share. Net investment income was higher than the dividend by $0.04 per share. Consequently, GAAP NAV went from $12.62 to $12.70 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.23 per share, flat quarter-over-quarter. 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 or 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. Our debt to equity ratio was 1.5 times while net debt to equity, after subtracting cash, was 1.4 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 $257 million drawn as of December 31. There's $87 million of unsecured senior notes maturing in 2023 and $228 million of asset-backed debt associated with PennantPark CL1 due 2031. During the December quarter, PFLT issued an additional $85 million of 4.25% 2026 unsecured senior notes, bringing the total principal balance 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 115 companies across 46 different industries. 87% 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 7.5%. 99% of the portfolio's holding is floating rate and 84% 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 goals are 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 payout those contractual 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.

And we will take our first question from Mickey Schleien with Ladenburg. Please go ahead.

Good morning, everyone. Art, did you accrue any past due interest or any other non-recurring items into interest income this quarter at PFLT?

I think I understand your question. I don't think we did. Could you clarify what you're getting at, Mickey?

I'm just doing the math; the effective yield looks a little higher than expected.

Yeah. Look, I think the growth of the joint venture is certainly helping out.

All right. And what caused the increase in other G&A expense this quarter? And what's the outlook for that line item?

Richard, do you want to handle that?

Sure. The G&A increase this quarter was because finance grew in size and activity volume. So, G&A expenses are largely made up of audit expenses, legal evaluation firm, sub-administration services, and those fees have gone up due to the increase in size and volume of activity. So, we do expect the G&A to continue at this pace that we've seen in the first fiscal quarter for the remainder of the year.

Okay. Thank you for that. Does your on-balance sheet credit facility and securitization measure collateral at fair value or at cost?

It's a classic CLO structure based on cost.

And the credit facility, Art?

The credit facility is based on cost as well.

Terrific. And how much leverage does the SLF credit facility allow, Art?

It's a special purpose vehicle. We have two types of debt involved in our joint venture. There's our securitization CLO and the SPV, which complement each other. In the SPV, the advance rate depends on the type of collateral, allowing for essentially two to one debt equity. The CLO itself can allow for even more leverage, as is typical for CLOs.

Okay. Thank you for that. I have a couple more questions, but I'll get back in the queue. Thank you.

Okay. Thank you, Mickey.

Our next question comes from Kevin Fultz with JMP Securities. Please go ahead.

Hi. Good morning and thank you for taking my questions. Clearly, the December quarter was really nice from a capital deployment standpoint, growing assets on balance sheet, as well as PSSL. I know over the past year, you've described the vintage as very attractive. Just curious how you would describe the deal-making environment and attractiveness of deals here in 2022.

Thank you for the question, Kevin. Let's discuss pacing. The year 2021 was remarkable in terms of deal activity, especially towards the end. Several factors contributed to this heightened activity. As for 2022, it seems unlikely to match the activity level of 2021. The year has started off typically, with a slower first quarter as people assess 2021 and recover from an active final quarter. We expect this year to be more normalized. If you consider 2019 as a benchmark for activity, that might be a reasonable expectation for our model in 2022 compared to 2021. Regarding the types of deals we are observing, we at PennantPark are focused on a market segment that is currently receiving less attention, allowing us to play a critical role for borrowers. As noted in several articles, the spotlight is on the upper middle market, where large investment firms have significant pools of direct lending capital and are competing aggressively. These firms are attempting to capture share from the broadly syndicated loan market. While that's positive, in the upper middle market, decision-making tends to be swift, leverage is elevated, covenants are minimal, and information rights are restricted. This situation benefits us, as it creates opportunities in the core middle market and even the lower middle market. Our capital is vital to borrowers; we have approximately 60 weeks to conduct thorough due diligence, which helps us understand our acquisitions better. Consequently, we are more essential to the borrower, which leads to higher yields, increased upfront fees, and substantial covenants. We also secure quarterly maintenance tests and receive monthly financial statements. Currently, we target companies with EBITDA between $10 million and $30 million, all of which have growth strategies, whether organic or inorganic. Our debt capital supports this growth, enabling us to benefit from equity co-investments. We invest in these $10 million to $30 million EBITDA companies alongside a sponsor, help them grow, and exit the debt when they move to the upper tier of the market, while still benefiting from our equity co-investment. This has been a favorable niche for us, and our returns have been strong over the past five to six years, particularly as larger players concentrate on higher market tiers.

Great. That's really helpful information, Art. And then just a follow-up question relating to interest rate sensitivity. Could you provide the weighted average LIBOR for floating rate investments?

Yeah. It's about 1%, Richard, right?

Yeah. That's right. The average LIBOR is 1%.

Okay. Thank you. And then I'll leave it there. Congratulations on a really strong quarter.

Thanks, Kevin.

And we'll take our next question from Paul Johnson with KBW. Please go ahead.

Yeah. Good morning guys. Thanks for taking my questions. Just going back to Mickey's question on the portfolio income, I know you said it doesn't sound like there are really that many non-recurring items in there. If I'm looking at it right, I think it was roughly $17 million of interest income in this quarter. It's like roughly a 7.5% yield on the debt portfolio. Do you see that as pretty sustainable for where the portfolio is today going forward?

Yeah. Look, as long as our credit quality remains strong, we do have some more rotation to do in that equity co-invest portfolio. We're going to talk more about pivot later at PNT, but PFLT does have a piece of pivot. So, we should continue to see more equity rotation. And certainly, as we increase this joint venture with Kemper, we're very hopeful that we can grow recurring NII to beat the dividend consistently.

Great. Thanks for that. My other question is regarding an investment in the portfolio. I'm just curious about marketplace events. I think that's been held on your books for some time. But the mark on that has been steadily going up over time. Do you have any update on that company or outlook as far as what's going on there?

Yeah. You can see it in the market. It's a trade show business, home goods, things of that nature. It's a really well-run company. We took control of it shortly after COVID, and they have operated very well through COVID, cutting costs appropriately while maintaining their strong cash position. Now that we are hopefully coming out of COVID in a more meaningful way, we think they're well-positioned to bounce back to their pre-COVID performance and hopefully more. They are the leaders in their industry, and we expect them to pursue add-on acquisitions that can continue to help grow EBITDA over the coming quarters, and we hope that EBITDA will recover nicely.

Okay, thanks for that. And then just the last question. Do you have any update on an estimated spillover amount from this quarter?

Richard, could you refresh us on what the spillover was? I don't think there's anything significant since the last quarter we announced. We announce spillover once a year in our September Q, but I believe it was around $0.20 a share, maybe $0.30, something like $0.20 per share.

Sure. Yeah. I think it was about $0.22 last quarter.

Yeah. That would have grown this quarter with the overage from September, in addition to that $0.05 or whatever it was, so it should be good enough for now. But we can follow up after.

And we'll take our next question from Mickey Schleien with Ladenburg. Please go ahead.

Art, just to follow up on that average floor in the debt portfolio. I think you said it was 1% on the balance sheet; is it similar in the senior loan fund as well?

Yeah. The typical floors are 1%, at least in our portfolios. I think we have a chart in the Q that shows what it would mean if LIBOR — if interest rates increase by 1%, I think it ends up being about hurting about a penny a share a quarter.

Right. Art, how do you feel about the scope to term out some of the credit facility's balance and help protect the balance sheet against rising interest rates?

Yeah. It's something we think about. It has to do with credit ratings and market conditions. We like the securitization market. As you know, the CLO market is great long-term capital, and it's possible to do some fixed rate, but mostly we're floating. We also like being matched so it's a plus and minuses. I think as interest rates increase, yes, we'll probably take a hit on NII. However, the growth of PSSL and the equity rotation should mitigate that, and at least we will be matched on the upside if and when rates rise.

Understand. Thank you. Last question. Art, how do you feel about the portfolio companies' ability on average to pass through inflation onto their customers?

It's something that goes to the core of how we rate and think about the companies we invest in. We're always asking ourselves the question, if this company goes away, does anybody care? Who cares if this company goes away? This really brings us to consider how important these companies are to their customers. Do they have pricing power and can they raise prices in a relatively easy fashion where customers accept those price increases? The average EBITDA margins in our portfolio exceeds 20%, which by definition indicates that they maintain attractive margins and are well-positioned with their customer base. Most of the companies that have asked for price increases so far have been able to secure them. And if they haven't asked for it, they are doing so right now. In this environment, these companies are getting results. They are important to their customers. The overall environment assists; costs are rising and it's reasonable for companies to request price increases. So far, we've had a very positive experience with pricing increases in the portfolio.

Thank you for that, Art. That's really helpful. Those are all my questions this morning.

Thanks, Mickey.

And our next question comes from David Miyazaki with Confluence Investment Management. Please go ahead.

Hi, good morning. Congratulations on the quarter. I wanted to discuss your strategy with PennantPark Floating, particularly your focus on floating rate coupons, which seems to be gaining traction in the industry. I would appreciate your thoughts on how the LIBOR floors might change as we head into a period where, based on the Fed's projections, we should see the reference rate around 100 basis points by the end of this year. Historically, many have not adjusted their floors upward during Fed tightening, typically concerning themselves more with it when the Fed is easing. Could you share your perspective on this?

Yeah. It's interesting. I mean, we'll see how the market evolves, David. Historically, when we've had a rising LIBOR, you can look back a couple of years when LIBOR was around 2.7% to 2.8%. There was some erosion of the LIBOR floor when it was above that. The majority of deals still retained LIBOR floors during that period. And by the way, some are looking at transitioning to SOFR floors as we proceed through the coming months. Historically, floors seem to have been a permanent part of the landscape, although some erosion occurs when SOFR or LIBOR are significantly above the typical floor. We'll have to see how things unfold this time around, especially if short-term rates exceed 100 basis points.

Do you have the ability to negotiate for a higher floor when LIBOR is above 2%, especially when people are not concerned about lower rates? Is that something you can achieve in your negotiations, or is that unlikely to happen?

Yeah. It's a great question. You're correct, the other side of this is that when LIBOR exceeds 2%, people are willing to agree to a 1% floor because it’s their preferred outcome. So, is there an opportunity to push for even a 1.25% or 1.5% floor? That’s certainly something we consider during negotiations. It really boils down to the specifics of the negotiation at that time — how much they need you, their alternatives, etc. PFLT, specifically, seeks to invest in the lower risk segment of the direct lending market. That has always been our approach here, aiming for lower risk while also accepting the lower reward, which aligns with our lower expense ratio. For conservative investors, PFLT remains an attractive option.

Okay. That's helpful. I also wanted to extend a little bit on your thoughts regarding the ability of your borrowers to pass inflation pressure through, as LIBOR floors have somewhat insulated your borrowers amidst the rise in rates. How do you perceive the pricing power within your borrowers' models to handle this duality of rising LIBOR and inflationary costs? Is there enough room in that 20% EBITDA margin?

Yeah, we think so. So far, it's been effective. Actual price increases can vary from 5% to 10% or more. The companies that have requested price increases have succeeded for the most part. When analyzing our credit stats, we note that we're over three times interest coverage — 3.3 times, to be precise. Thus, we feel reasonably secure. Of course, we wish we had more upside when the Fed was raising rates, but we benefited from healthy yields as rates dropped and during the pandemic. While we can't complain about that, we believe that if we select the right credits, the cushion built into our credit stats will offer sufficient protection.

Okay. Great. Thank you very much, and congratulations again on the quarter.

Thanks, David.

There are no further questions at this time. I will now turn the conference back to Mr. Penn for any closing remarks.

Thanks everybody. We really appreciate your attendance today. Next time we chat, it'll be in early May for our March quarter. So, thanks, everybody. Take care.

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