Earnings Call Transcript - PFLT Q4 2022

Operator, Operator

Good morning and welcome to the PennantPark Floating Rate Capital's Fourth Fiscal Quarter 2022 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 of PennantPark Floating Rate Capital. Mr. Penn, you may begin your conference.

Art Penn, Chairman and CEO

Thank you and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's fourth fiscal quarter 2022 earnings conference call. I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Richard Allorto, CFO

Thank you, Art. I'd like to remind everyone that today's call is being recorded. Please note that this call is the property of PennantPark Floating Rate Capital and that any unauthorized broadcast of this call in any form is strictly prohibited. An audio replay of the call will be available 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.

Art Penn, Chairman and CEO

Thanks, Rick. We're going to spend a few minutes discussing how we fared in the quarter ended September 30, how the portfolio is positioned for upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open it up for Q&A. For the quarter ended September 30, our core net investment income was $0.30 per share, which includes $0.01 of other income and excludes $0.01 per share of one-time upfront financing costs from the $66 million increase in our revolving credit facility. The credit quality of the portfolio remains solid, and we did not have any new nonaccrual investments. As of September 30, we had only 2 nonaccruals out of 125 different names in PFLT. This represents only 0.9% of the portfolio at cost and 0.01% at market value. Our credit statistics remain among the most conservative in the industry with an average debt-to-EBITDA on our underlying portfolio of 4.7x and interest coverage of 3x. Our NAV decreased from the prior quarter, due primarily to unrealized mark-to-market adjustments tied to the overall market and not due to fundamental credit factors. GAAP NAV decreased by 4.8%, of which 3.3% was due to market-related fair value adjustments. The remainder of the decrease in GAAP NAV was primarily due to fair value adjustments on our credit facility and notes. With the debt portfolio that’s 100% floating rate, we are well positioned to substantially grow our net investment income as base rates rise. The weighted average yield to maturity on our portfolio increased to 10% from 8.5% last quarter. Holding everything else constant in the portfolio, every 100 basis point increase in base rates translates into about $0.03 per quarter of NII. We believe that this late 2022 and 2023 vintage of middle-market directly originated loans should be excellent. Leverage is lower. Spreads and upfront fees and OID are higher and covenants are tighter. Our capital, which we believe is always value-added, is adding even more value in this environment. During the quarter, we continued to originate attractive investment opportunities for both the PFLT portfolio as well as the JV portfolio. At quarter end, the JV portfolio was $757 million, and we will continue to execute on our plan to grow the JV portfolio to $1 billion of assets. We believe that the increase in scale and the JV's attractive ROE will enhance PFLT's earnings momentum. From an overall perspective, in this market environment of inflation, rising interest rates, geopolitical risk, and potentially weakening economy, we believe we are well positioned. We like being positioned for capital preservation as a senior secured first lien lender focused on the United States, where floating rates on our loans can protect against rising inflation. We continue to believe that our focus on core middle market provides the company with attractive investment opportunities where we are an important strategic capital to our borrowers. In times of market volatility, our direct lending strategy focuses on creating value from the dislocation in the markets. Specifically, we've been active in buying first lien loans in the secondary market at discounts in companies where we believe we have differentiated institutional knowledge. It could be a company that we used to finance and a sector where we have domain expertise or direct relationships with the management team or a financial sponsor. We have been buying loans where we think we can generate double-digit or low teens IRRs as the loans return to par in 3 years. We employed a similar strategy during the global financial crisis and generated excellent returns. We have a long-term track record of generating value by successfully financing high-growth middle-market companies in 5 key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask and have an excellent track record. They are business services, consumer, government services and defense, health care and software and technology. These sectors have been resilient and tend to generate strong free cash flow. It's important to note that we do not have any crypto exposure in our software technology investments. In many cases, we're typically part of the first institutional capital into a company where a founder, entrepreneur, or family is selling their company to a middle-market private equity firm. In these situations, there's typically a defined game plan in place with substantial equity support from the private equity firm to significantly grow the company through add-on acquisitions or organic growth. The loans that we provide are important strategic capital that fuel the growth and help that $10 million to $20 million EBITDA company grow to $30 million, $40 million, $50 million of EBITDA or more. We typically participate in the upside by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall, for our platform from inception through September 30, our $355 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.5x. With the current volatility in the broadly syndicated loan market, we have seen more private equity sponsors tap the private credit markets. We are selectively looking at these new opportunities and believe the vintage for these loans will yield compelling returns. Because we are an important strategic lending partner, the process and packaging terms we receive are attractive. We have many weeks to do our due diligence with care. We thoughtfully structure transactions with sensible credit stats, meaningful covenants, substantial equity cushions to protect our capital, attractive upfront fees and spreads, and equity co-investments. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, virtually all of our originated first lien loans have meaningful covenants which help protect our capital. This is one reason why our default rate and performance during COVID was so strong and why we believe we are well positioned in this environment. This sector of the market, companies with $10 million to $50 million of EBITDA, is the core middle market. The core middle market is below the threshold and does not compete with the broadly syndicated loan or high-yield markets. Many of our peers, who focus on the upper middle market, state that those bigger companies are less risky. That may make some intuitive sense, but the reality is different. 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 loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence, and tighter monitoring have been an important part of this differentiated performance. The borrowers in our investment portfolio are generally performing well. As we said earlier, as of September 30, the weighted average debt-to-EBITDA on the portfolio was 4.7x, and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3x. This provides a significant cushion to support stable investment income even as interest rates rise. Based on this substantial cushion, even with the 200 basis point rise in base rates and a flat EBITDA, our portfolio companies will cover their interest 2.1x on average. These stats are among the most conservative in the direct lending industry. Our credit quality since inception over 10 years ago has been excellent. PFLT has invested $5 billion in 451 companies, and we've experienced only 15 nonaccruals. Since inception, PFLT's loss ratio is only 6 basis points annually. Our experienced and talented team and our wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors. Our mission and goal are a steady, stable, and protected dividend stream, coupled with the preservation of capital. Everything we do is aligned to that goal. We seek to find investment opportunities in growing 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. Let me now turn the call over to Rick, our CFO, to take us through the financial results in more detail.

Richard Allorto, CFO

Thank you, Art. For the quarter ended September 30, net investment income was $0.29 per share, including $0.01 per share of other income. Operating expenses for the quarter were as follows: management fees and performance-based incentive fees were $6.2 million, interest and credit facility expenses were $9 million, general and administrative expenses were $800,000, and provision for taxes were $100,000. Core net investment income was $0.30 per share, which excludes $0.01 per share of one-time upfront financing costs from the $66 million increase in our revolving credit facility. For the quarter ended September 30, net realized and unrealized change on investments, including provision for taxes, was a loss of $19.6 million or $0.45 per share. The unrealized appreciation on our credit facility and notes for the quarter was $6.2 million or $0.14 per share. As of September 30, our GAAP NAV was $11.62, which is down 4.8% from $12.21 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.59 per share, down from $12.02 last quarter. Our GAAP debt-to-equity ratio, net of cash, was 1.19x for the quarter. Our capital structure is diversified across multiple funding sources, and we do not have any near-term maturities. During the quarter ended September 30, we increased our revolving credit facility by $66 million at the existing spread. As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 125 companies across 46 different industries. The portfolio was invested in 87% first lien senior secured debt, including 16% in PSSL, less than 1% in second lien debt, and 13% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 10%, and 100% of the debt portfolio is floating rate. As of September 30, 2022, the company had approximately $0.26 per share of spillover taxable income. I'll now turn the call back over to Art.

Art Penn, Chairman and CEO

Thanks, Rick. In closing, I would like to thank our dedicated and talented team of professionals for their continued commitment to PFLT and its shareholders. 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.

Operator, Operator

We will take our first question from Paul Johnson from KBW.

Paul Johnson, Analyst

I was wondering if you could discuss one of the investments in the portfolio that is also in the joint venture. There have been some recent developments with a company called Walker Edison since the end of the quarter. Can you share any updates on that along with the level of exposure in both the portfolio and the joint venture? I'm curious about how much exposure you have in this area.

Art Penn, Chairman and CEO

Yes, thanks, Paul, and good morning. We have about $12 million invested in Walker Edison through PFLT and roughly the same amount in the joint venture. As of September 30, it was valued at approximately $0.68 on the dollar. They did pay us cash interest as of that date, so it was recorded on an accrual basis for the quarter. There are ongoing discussions regarding restructuring. We hope to have more information to share by the next quarterly earnings announcement in early February or as of December 31. The restructuring discussions are still in progress, and it could be on a nonaccrual basis as of December 31, but we will see when the time comes.

Paul Johnson, Analyst

Can you discuss the overlap between the joint venture and the PFLT portfolio? Is the goal of the joint venture to closely align with PFLT's deal flow and maintain a high level of overlap, or is there a focus on differentiation? I'm curious about the percentage of overlap between the two portfolios.

Art Penn, Chairman and CEO

That's a good question. People utilize their joint ventures in various ways within our industry. For us, at PFLT, it serves as an extension allowing us to handle larger investments. It remains comparable to our first lien senior secured floating rate portfolio. You will notice many transactions that overlap between both the BDC and the joint venture. The joint venture does not take equity co-investment, which remains within the BDC. As you know, the co-investment has performed well, achieving nearly a 2.5x multiple on invested capital over 16 years. Thus, the BDC retains the co-investment.

Paul Johnson, Analyst

Got it. I have a question about the liabilities. I understand you have some bonds that are gradually amortizing and are set to mature in 2023. I'm curious, in the current market, if there is a preference for refinancing options, although I realize that may not be the focus right now. Specifically, is there a significant cost difference between borrowing in the unsecured market and securitization? Has that gap narrowed with rising rates, and is securitization a viable option in this market?

Art Penn, Chairman and CEO

Yes, we do have some unsecured bonds maturing at the end of 2023, giving us some time to explore capital structure options. In the long term, we believe unsecured bonds should be an important part of a diversified liability stack, as we prefer a variety of components. However, there are times when it may be more advantageous to pursue a regular credit facility, securitization, or bonds. In 2021, PFLT issued bonds that were quite attractive, and we will assess our options over the next year to find the best path forward. Some options may be suited for the long term, while others could be short-term, depending on market conditions in the next 6 to 9 months. Currently, bonds are available but are pricey. Securitizations are also available, but again, they are more costly compared to 6 to 9 months ago. Comparatively, securitization tends to be less expensive than long-term bonds, which would lock us into a high fixed yield. If decisions were being made today, we would likely increase the credit facility we expanded by $66 million last quarter, or consider potential securitization. We will keep an eye on the market, and all options are open for the next year.

Paul Johnson, Analyst

I understand, thank you for that. I have two more questions, if I may. First, regarding the unrealized marks for the quarter. You mentioned that Walker & Dunlop is marked lower, which seems more related to credit. I'm curious about the $20 million, excluding liability adjustments. Could you provide a general idea of how much of that is related to mark-to-market versus other credit issues or any one-time factors that could be influencing that?

Art Penn, Chairman and CEO

I believe Walker Edison is the only exception when it comes to unrealized mark-to-market loss, which was around $0.11 per share. Fortunately, the rest of the items are quite minimal. We view this as primarily market-related issues rather than actual credit deterioration, except for Walker Edison. We feel confident about our portfolio. Having a portfolio with a mid-4s debt-to-EBITDA ratio provides us with a comfortable cushion. We've addressed interest coverage, and while interest coverage for all the companies in our industry is declining due to higher floating rates, our portfolio is still well-equipped to handle potential challenges. This is true both in terms of credit metrics and capital structure, and the industries we operate in are generally more resistant to recession.

Paul Johnson, Analyst

Got it. And then last question for me just on inflation and sort of EBITDA trends for your borrowers. I'm just curious as you're getting any sort of updated forecast or financial statements from your borrowers, where has that trended in terms of forecast for EBITDA growth? Is that continue to come down? Has that been fairly stable? And alongside that, inflation, I guess, just the company's ability to continue to pass that on. I think that's pretty much been the case as long as inflation has been going on in the economy but have you started to see any limits to that?

Art Penn, Chairman and CEO

Yes, we haven't observed any limits on companies’ ability to pass on price increases at this time. The good news is that costs for items like containers and shipping from Asia or other locations are decreasing significantly. We are optimistic that as 2022 transitions into 2023, supply chain cost issues will lessen, meaning companies may have less need to implement price hikes for their end customers. Regarding EBITDA, there are various factors at play. It’s not showing the same upward trend as seen post-COVID; rather, it’s a slight increase or flat environment. Some companies are more affected than others, but overall, from a portfolio perspective, it’s showing a slight upward trend compared to the significant increases seen after COVID.

Operator, Operator

We will now take our next question from Mickey Schleien from Ladenburg Thalmann.

Mickey Schleien, Analyst

Art, I wanted to ask you about your perspective on the current vintage's attractiveness. Generally, we're hearing a lot of excitement around it due to wider spreads and improved deal terms. However, your on-balance sheet portfolio has declined, and the SLF portfolio saw only slight growth. Can I take this to mean that you might not be as enthusiastic as others, or was there another reason we didn't observe more portfolio growth this quarter at PFLT?

Art Penn, Chairman and CEO

In terms of the portfolio, we received some repayments, including a significant one from a company called Crash Champions, which was sold. This amounted to about $35 million between the joint venture and the business development company. Additionally, we saw two deals totaling around $17 million from the two entities. The leverage was so low that traditional commercial banks stepped in. These companies were leveraged around three times, and they successfully obtained favorable financing from commercial banks. It's hard to find fault with that. The credits were solid, and we anticipated they would be good candidates for refinancing. Overall, we are enthusiastic about the environment and hopeful for growth this quarter and beyond in both the BDC and the joint venture. We are noticing a new wave of deals due to lower leverage, higher yields and spreads, increased original issue discounts, and tighter covenants. The substantial equity cushion is shaping up to be promising. We also see an opportunity in the secondary market where we can buy assets for between $0.85 and $0.95 on the dollar in companies we know well. If we perceive that it's likely to return to par in two to three years, it could yield a favorable return. We are pursuing this strategy in both the joint venture and the BDC while capitalizing on some market softness.

Mickey Schleien, Analyst

I understand. That's really helpful. A couple of more questions from me. If I'm doing the math right, it looks like the dividend to the BDC from the SLF declined pretty meaningfully in the fourth quarter versus the last couple of quarters. I understand that there's obviously differences between cash and tax and GAAP bookkeeping. But was there some underlying reason for that? And what is the outlook for the dividend from the senior loan fund?

Art Penn, Chairman and CEO

Yes, there is no decline in income from the joint venture, including our floating rate debt investment in the JV, as the overall income is stable or increasing. Although LIBOR has risen, the income from the JV remains unchanged. However, a larger portion of this income is being used to cover the debt, resulting in less income for the equity share.

Mickey Schleien, Analyst

So you're looking at a return on invested capital basis.

Art Penn, Chairman and CEO

I don't have the specifics, but it's clear that the note flowing into the joint venture has a strong spread over LIBOR.

Mickey Schleien, Analyst

Yes. I got it. My last question, the marketplace advance first lien is marked well above cost. And I think it's been like that for a couple of quarters. Does that imply that you're expecting to exit that investment relatively soon? Or is something else there?

Art Penn, Chairman and CEO

We certainly hope to exit marketplace events when the time is right. The company is performing well. It's a trade show business focused on home goods and has rebounded nicely. This reflects on whether now is the right time to sell or if we should wait a bit longer to ramp up. I don't believe it's a short-term decision because we see strong growth potential for that company right now. It plays a consolidating role in its industry. We're always evaluating options, but we don't view this as a short-term matter. Over the intermediate to long term, we believe there is significant potential to build that company and, subsequently, increase its value in the PFLT portfolio due to the positive trends we're observing. People are returning to trade shows, which are very popular, and they appreciate the in-person interactions. Therefore, we are considering holding onto it for a while and seeing it through.

Mickey Schleien, Analyst

So just so I make sure I understand. The mark of above cost is related to the restructuring rather than expectations of near-term exit, is that correct?

Art Penn, Chairman and CEO

Yes, there is equity involved, meaning we have control of the company. Together with three other lenders, we are in control, and we are the lead lender. The increase in markup is a result of the company's valuation rising.

Operator, Operator

Mr. Penn, I'd like to turn the conference back to you for any closing remarks.

Art Penn, Chairman and CEO

I just want to thank everybody for being on the call this morning. We appreciate it. Wishing everybody a terrific Thanksgiving and a great holiday season and we look forward to speaking with you in early February at our next earnings call.

Operator, Operator

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