Earnings Call Transcript - PFLT Q1 2024

Operator, Operator

Good morning and welcome to the PennantPark Floating Rate Capital's First Fiscal Quarter 2024 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.

Arthur Penn, Chairman and CEO

Thank you and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's first fiscal quarter 2024 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 those 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 or call us.

Arthur Penn, Chairman and CEO

Thanks, Rick. We're going to spend a few minutes discussing the current market environment for middle market lending, how we fared in the quarter ended December 31, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, then open it up for Q&A. For the quarter ended December 31, GAAP and core net investment income was $0.33 per share. GAAP and adjusted NAV increased 0.6% to $11.20 per share from $11.13 per share. The increase in NAV for the quarter was due primarily to positive valuation adjustments on both debt and equity investments. As of December 31, our portfolio grew to $1.3 billion or 19% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities and invested $303 million in 13 new and 34 existing portfolio companies at a weighted average yield of 11.9%. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.8x. The weighted average interest coverage was 2.4x and the weighted average loan to value was 51%. On average, we have seen a 25 basis point tightening on first lien spreads. However, we continue to believe that the current vintage of core middle market directly originated loans is excellent. Leverage is lower, spreads in upfront OID are higher, covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market and the core middle market, we are still getting meaningful covenant protections. Our deal flow continues to be very active. And since quarter end, we invested $103 million into new and existing investments. As of December 31, our debt-to-equity ratio was 1.02:1. With a target ratio of 1.5:1, we believe that we are well positioned to drive additional growth in net investment income going forward. We expect additional growth in NII in part to be driven by our investment in the joint venture. As of December 31, the JV portfolio totaled $837 million. Together with our JV partner, we continue to execute on the plan to grow the JV portfolio to approximately $1 billion of assets. During the quarter, the JV invested $76 million in 4 new and 9 existing portfolio companies at a weighted average yield of 12.3%, including $75 million of assets purchased from PFLT. We believe that the increase in scale of the JV's balance sheet will continue to drive attractive mid-teens returns on invested capital and enhance PFLT's earnings momentum. Credit quality of the portfolio was stable. We had no new non-accruals in the quarter ended December 31 and we restructured 2 investments that were on non-accrual resulting in the return to accrual status. As of December 31, the portfolio's weighted average leverage ratio through our debt security was 4.8x. Despite the steep increase in base rates during 2023, the portfolio's weighted average interest coverage ratio at December 31 was 2.1x. In an uncertain market environment, we like being positioned for capital preservation as a senior secured first lien lender focused on the United States. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities where we provide important strategic capital to our borrowers. We have a long-term track record of generating value by successfully financing growing 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 also been resilient and tend to generate strong free cash flow. Approximately 12% of our portfolio is in government services and defense, which is a sector with strong tailwinds in this geopolitical environment. In our software vertical, we don't have any exposure to ARR loans. The core middle market, which includes companies with $10 million to $50 million of EBITDA, is below the threshold and does not compete with a broadly syndicated loan or high-yield markets, unlike our peers in the upper middle market. In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive are attractive. We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, upfront OID, and equity co-investment. Additionally, from a monitoring perspective, we received monthly financial statements to help us stay on top of the companies. With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated first lien loans had meaningful covenants which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. 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. Our credit quality since inception over 13 years ago has been excellent. PFLT has invested $5.6 billion in 481 companies and we have experienced only 18 non-accruals. Since inception, PFLT's loss ratio on invested capital is only 0.13% annually. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company 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 December 31, we've invested over $448 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1x. Our experienced and talented team and 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. 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 December 31, GAAP and core net investment income was $0.33 per share. Operating expenses for the quarter were as follows: interest and expenses on debt were $8.9 million, base management and performance-based incentive fees were $7.8 million, general and administrative expenses were $1.6 million, and provision for taxes were $154,000. For the quarter ended December 31, net realized and unrealized change on investments, including provision for taxes was a gain of $3.1 million or $0.05 per share. The unrealized appreciation on our credit facility and notes for the quarter was $0.1 million. As of December 31, our GAAP NAV was $11.20 per share which is up 0.6% from $11.13 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $11.20 per share, up 0.6% from $11.13 per share last quarter. As of December 31, our debt-to-equity ratio was 1.02x and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. During the quarter, we used liquidity from our revolving credit facility to repay the $76 million of unsecured notes that matured on December 15. As of December 31, our key portfolio statistics were as follows: our portfolio remains highly diversified with 141 companies across 33 different industries, the weighted average yield on our debt investments was 12.5%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 2% of total investment income for the quarter. We had one non-accrual which represents 0.1% of the portfolio at cost and 0% at market value. We did not put any new investments on non-accrual during the quarter. The portfolio is comprised of 86% first lien senior secured debt, less than 1% in second lien debt, 4% in equity of PSSL, and 9% in other equity. The debt to EBITDA on the portfolio is 4.8x and interest coverage was 2.1x.

Arthur Penn, Chairman and CEO

Thanks, Rick. In closing, I'd 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 Brian McKenna with JMP.

Brian McKenna, Analyst

Great. So it's good to see the pickup in origination activity during the quarter. And then it seems like this momentum has carried into the new calendar year. So what's the base case expectation for investment activity looking out over the next few quarters? And then when you look at the new portfolio companies you've invested in more recently, where do the majority of these investments sit from a sector perspective?

Arthur Penn, Chairman and CEO

Thanks, Brian. Just I'll answer the second one first. The sectors remain the same. We're doing quite a bit in government services and defense, which, as you might imagine, is an active sector. We're doing quite a bit in health care, in sectors of health care that we like that have strong free cash flow and that are performing. And then just to run the gamut, business services are kind of where we've been most active recently. In terms of expectations, it's a great question. Of course, we don't really know. We do believe that 2024 will be an active year overall. Certainly, in the first calendar quarter of '24, it's been more active than normal. Usually, the first calendar quarter is light. From the standpoint of activity level, this has been a more moderate activity for us in Q1. So kind of we do believe that if we're sitting here a year from now, we'll be active with 2024, but we don't know what the ensuing quarters will bring.

Brian McKenna, Analyst

Got it. Helpful. And then maybe just a follow-up on leverage. So that increased pretty meaningfully in the quarter but that's from a pretty low base in the prior quarter. So sitting at about 1x today, it's still kind of at that lower end of the range. So I guess, how should we think about the trajectory of leverage from here? And then I guess, again, what scenario or deployment environment would ultimately drive leverage notably higher from here?

Arthur Penn, Chairman and CEO

Our long-term target remains around 1.5x leverage for this lower risk first lien portfolio. We are prepared for opportunities as they arise. Currently, we have a strong position and believe this generation of investments will continue to perform well. We've provided some credit statistics showing low leverage, favorable loan to value ratios, and strong interest coverage in this cohort. We aim to actively pursue high-quality deals while maintaining a selective approach to ensure they align with our criteria. Over time, we have refined our selection process, which has contributed to our low non-accrual rate and solid credit metrics. The timing for reaching 1.5x leverage will depend on expectations for origination and market conditions. However, we are confident in our resources and our capacity to take advantage of this excellent investment environment. If we can achieve significant net investment income and returns on equity at lower leverage, it could yield substantial benefits for our shareholders as we strategically deploy capital over time.

Operator, Operator

We will take our next question from Paul Johnson with KBW.

Paul Johnson, Analyst

You somewhat addressed my question regarding your outlook for activity, but I am interested in understanding what led to the increased originations in the recent quarter. Was it mainly due to the attractive loans available, or were there other factors involved, such as timing or pending issues? I'm really asking what contributed to the high activity in the fourth quarter.

Arthur Penn, Chairman and CEO

Yes. And it's a good question. And our business model is one where, in many cases, we're providing that initial loan to a company that's a platform investment for a private equity sponsor who sees growth opportunity, typically add-on acquisitions in a particular industry or sector. So much of this was not refinancing or opportunistic financing, which is probably a lot of what you see in the upper middle market. The vast majority of this is platform deals and then the add-on investments to fuel the growth of these sectors. So, a typical investment for us will start out with a company that does $20 million of EBITDA, but the goal is to get it to $40 million or $50 million or higher over time. We make our initial platform loan, and then we become their strategic partner. And you saw quite a bit of kind of add-on incremental delayed draw activity, and that's a big part of what we do and it remains. So certainly, overall M&A trends are important around here. But in many cases, this is driven by fundamental opportunity in particular sectors where our private equity sponsor partners are finding areas of opportunity.

Paul Johnson, Analyst

Yes. Thanks for the detail on that. That's very helpful. And then I mean, are these investments that you would expect to probably hold on to? Or are these going to find their way into the JV at some point?

Arthur Penn, Chairman and CEO

Yes. So it's a good question. The JV typically takes a pro rata piece to the extent it has liquidity, and it does, pro rata piece of the deals that we originate. The JV has a couple of hundred million of liquidity. So over time, much of what's new will find its way into the JV, which is a highly diversified portfolio. And certainly, it's certainly been a nicely accretive vehicle for our PFLT shareholders and we hope it continues to be so.

Paul Johnson, Analyst

And then my last question was just on the large increase in equity investments this quarter, I'm just curious if there was any kind of significant investments that you guys made in the quarter that drove that? Or was that just more of a function of the higher activity in co-investments that you received during the quarter?

Arthur Penn, Chairman and CEO

Yes. No, there was just really a function of the high activity. In many cases, as we say, we will co-invest in the equity. And we are starting to see, thankfully, some repayments, and many of those repayments are actual exits where we hope to be rotating successful equity co-investments that we've made. There's one that just closed the other day which is a 3x MOIC. So we're starting to see some rotation, which is nice. But again, this will go back to kind of deal activity, kind of what's overall deal activity, is it a good time to exit or the sponsors who've been holding on, are they going to exit and take the win? Or are they going to hold on? So I'd expect as things get busier, we'll be able to rotate that equity portfolio from existing names into new names.

Operator, Operator

We will take our next question from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Art, this quarter's fee income was the highest it's been in a couple of years. Were there any outsized prepayment fees in the activity this quarter or what else could have caused that amount?

Arthur Penn, Chairman and CEO

There was a significant amount of activity this quarter, including one or two larger amendments, but those were not the main factors driving the activity. We experienced considerable new loan activity, making it an overall active quarter.

Mickey Schleien, Analyst

Okay. And in terms of your unfunded commitments in the Q, it says it's about $270 million. What proportion of that is at the discretion of the portfolio companies?

Arthur Penn, Chairman and CEO

So it's about half revolver and half delayed draw. The revolvers are decided at the company's discretion. Delayed draws typically require meeting certain covenants or performance thresholds, and often involve finding additional deals. This is usually the reason for opting for delayed draws, as there is a desire to consolidate within a specific industry. In times of turmoil, like during COVID or the Global Financial Crisis, many borrowers tend to rely on revolvers, whereas delayed draw activity often drops to zero because there are no additional acquisitions. Looking at the couple of hundred million we have, it's evenly split. If another situation like COVID arises, the revolvers may not be fully drawn but would likely be at least half drawn, while delayed draw activity would cease.

Mickey Schleien, Analyst

Okay, fair enough. Talking about the right side of the balance sheet, Art, you're now in a position where about 3/4 of your debt liabilities are in the credit facility at floating rates. Are you comfortable leaving it that way and potentially taking advantage of declining rates later this year? Or are you looking at issuing some more unsecured debt and unlocking some of the capacity from the revolver?

Arthur Penn, Chairman and CEO

Yes. I think before unsecured debt, the CLO securitization technology is a really good liability management tool, particularly for these lower-risk first lien loans. So middle-market CLOs are kind of becoming a darling in the CLO market. I know you cover CLOs, Mickey. And we have a very good track record as a CLO, middle-market manager in our BDCs and our JVs and as well as for third-party investors. So probably step on to create liquidity for the revolver is a securitization. And of course, we're always looking at the unsecured markets. We have a big slug of unsecured paper that doesn't mature until 2026; that's a four-handle. So we're in no rush with yields coming down. We can be opportunistic about unsecured. It certainly is part of the tool chest, but we don't really need it right now, particularly when we can get for efficient securitization financing.

Mickey Schleien, Analyst

And Art, if you were to do a new securitization through a CLO structure, any sense of where that would be priced in today's market?

Arthur Penn, Chairman and CEO

Yes. I mean, it would probably be low $200s million, $230-ish million.

Operator, Operator

We will take our next question from Mark Hughes with Truist.

Mark Hughes, Analyst

Art, you mentioned a strong interest coverage ratio of 2.1x for the portfolio. Can you share what percentage might be around 1x or below? Also, how do you anticipate credit trends will evolve over the next six to twelve months?

Arthur Penn, Chairman and CEO

Yes, we don't have the exact numbers on interest coverage, but we do have over 100 loans, and while there will always be a few that are underperforming, I'm referring to about 3 to 6 that are on our major watch list. If you review the mark-to-market and fair value reports, you can identify which ones they are. Overall, our portfolio is quite clean at this moment. It's uncertain whether this will continue, especially given the rising interest costs. The environment has been favorable for us and possibly for the entire market, but it's hard to predict how long this will last. We should expect it to be less favorable going forward, although the economy appears to be strong. If interest rates begin to decline and the Fed eases, it could provide some relief for the tighter capital structures that are dealing with lower coverage. Currently, we're in a solid position with very few non-accruals and only a few names on the severe watch list, but we're being cautious. With the new deals we are pursuing, we've found some lower-risk, attractive return investments. As our portfolio expands with these new additions, the significance of the underperforming loans will diminish in the overall picture.

Mark Hughes, Analyst

Yes, understood. And then you mentioned the covenants you think you're seeing erosion at the upper end of the market but you're holding pretty firm that those covenants, how do they compare with what you might have seen normal course of business, say, pre-COVID, still pretty rich. Are you going to see some erosion even perhaps within your packages?

Arthur Penn, Chairman and CEO

Yes, I believe we are back to pre-COVID levels with reasonable safeguards in place. We receive monthly financial statements, and I would say we are indeed back to where we were before the pandemic. In contrast, 2022 and early 2023 were tighter periods, and conditions could tighten again. We've indicated that spreads have decreased by 25%, and along with that, the covenants are returning to pre-COVID norms. Remember, before the pandemic, we had about 150 loans across our platform. The quarterly maintenance tests and the monthly financial statements required from sponsors allowed us to engage proactively during COVID. Many sponsors anticipated missing these tests, and having access to monthly financial information enabled us to address issues and determine liquidity needs early on. Now, we have returned to pre-COVID covenants and information rights, which served us well during the pandemic in the core middle market. Of the 150 loans in our portfolio, only 15 needed cash liquidity to navigate through COVID, and in each case, the sponsors were willing to inject capital to resolve the issues. This highlights the advantage of having monthly information rights and quarterly maintenance covenants. In comparing the core middle market to the upper middle market, we prefer the core middle market where these protections and information rights allow us to react quickly.

Operator, Operator

We will take our next question from Vilas Abraham with UBS.

Vilas Abraham, Analyst

I just had a question on repayments. Can you share any kind of line of sight that you have repayments, prepayments for the first half of the year? And presumably, if origination activity continues to be strong, repay should pick up as well? And just kind of talk about that and if that would be a bit of an impediment in getting to your leverage goals.

Arthur Penn, Chairman and CEO

Yes. We are beginning to see some repayments. While they are not significant and do not match our originations, these repayments suggest that mergers and acquisitions might be starting to increase. We appreciate receiving repayments, as there are times when that doesn't happen. In many instances, this also means we are generating cash from our equity co-investments. Some of this is already occurring, which is positive. We are also originating new deals, and we do not feel pressured to reach a specific ratio for the sake of analysts' models in the coming quarters. Each deal needs to stand on its own merit, and we follow a strict process for evaluation. We are confident we will reach our targets in due time. We are currently exceeding our dividend in a low-leverage environment, with our joint venture not fully deployed, which gives us a healthy buffer for dividends. We believe that having leverage on our balance sheet and the joint venture's balance sheet provides us with a strong position to pursue high-quality deals in what we anticipate will continue to be a favorable market. We are not rushing things because we recognize that haste often leads to poor outcomes. We expect 2024 to be an active year for deal flow.

Vilas Abraham, Analyst

Okay, great. My other question is regarding yield and spread dynamics. It appears that your average yields for new deals in Q4 were 11.9%, and the average portfolio is higher than that. However, so far this quarter, I noticed weighted average yields around 13%. Can you discuss the slight fluctuations in this area and what we can anticipate in terms of trends in the near future?

Arthur Penn, Chairman and CEO

Yes, that's a typo. 13% is a typo; closer to 12% for quarter-to-date. So that's very much in line with what we've been doing.

Operator, Operator

We do not have any further questions in the queue. I will now turn the call back to Mr. Art Penn for closing remarks.

Arthur Penn, Chairman and CEO

Thank you. I want to thank everybody for their participation. We look forward to speaking to you next in early May.

Operator, Operator

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