Earnings Call Transcript - PFLT Q3 2021

Operator, Operator

Good morning and welcome to the PennantPark Floating Rate Capital's Third 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.

Arthur Penn, Chairman and CEO

Thank you. And good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's third fiscal quarter 2021 earnings conference call. I'm joined today by Richard Cheung, our new Chief Financial Officer. Richard joined us in June from Guggenheim Partners where he was Head of Alternative Investment Accounting for many years. Prior to Guggenheim, he was at Ernst & Young. We are thrilled that Richard has joined us and are confident that his extensive experience will be a tremendous asset to the company. We thank Aviv Efrat for all his contributions to PFLT since inception and are grateful that he is continuing with PennantPark focusing on strategic initiatives. Richard, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Richard Cheung, CFO

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 any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release as well as on our website. I also like to draw your attention to the customer Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent 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.

Arthur Penn, Chairman and CEO

Thanks, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ended June 30th, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, and then open it up for Q&A. We are pleased with our performance this past quarter. Our net investment income grew to $0.27 per share while our credit quality and NAV performance remained solid. We are poised to significantly grow NII through a three-pronged strategy, which includes: number one, growing assets on balance sheet at PFLT, as we move towards our target leverage ratio of 1.5 times debt to equity from 1.1 times. Number two, growing our PSSL JV with Kemper to about $730 million of assets from approximately $500 million. And number three, rotating the equity value in the portfolio that has come from a 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. During the June quarter, PFLT invested $20 million of capital and we intend to invest another $42 million over time in order to bring PFLT’s investment into 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. The returns on these equity co-investments have been excellent over time. Overall, for our platform from inception through June 30th, our $237 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.9 times. In a world where investors 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. Since June 30th, PFLT has had new originations of $102 million and PSSL has had new originations of $29 million. Although in the June quarter repayments exceeded new loans, in the September quarter so far, repayment activity has abated and new originations have accelerated. Our portfolio performance remains strong. As of June 30th, the average debt to EBITDA in the portfolio was 4.2 times and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.3 times. This provides a significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. We have only two non-accruals out of 105 different names in PFLT and PSSL. This represents only 2.8% of the portfolio cost and 2.7% at market value. We have largely avoided some of the sectors that have been hurt the most by the pandemic such as retail, restaurants, health clubs, apparel, and airlines, and PFLT also has no exposure to oil and gas. The portfolio is highly diversified with 100 companies in 42 different industries. Our credit quality since inception over 10 years ago has been excellent. Out of 381 companies in which we have invested since inception, we've experienced only 14 non-accruals. Since inception, PFLT has invested over $4.2 billion at an average yield of 8%. This compares with a loss ratio of only 7 basis points annually. We are one of the few middle-market direct lenders who was 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 and 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 the recession. This compares to the average EBITDA decline in the Bloomberg North American High Yield Index of 42%. Based on tracking EBITDA of our underlying 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 in 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 and where we have a meaningful domain expertise. The outlook for new loans is attractive. We are as busy as we've ever been in 14 years in business, reviewing and doing new deals. With our experienced, 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 about what ends up in our portfolio. 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 a broadly syndicated loan or high-yield markets. As such, we do not compete with markets where leverage is higher, equity cushion is lower, covenants are light, wide, or non-existent, information rights are fewer, EBITDA adjustments are higher, and less diligent, and the timeframe 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 stay on top of the companies, EBITDA adjustments are more diligent and 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. Let me now turn the call over to Richard, our CFO, to take us through the financial results in more detail.

Richard Cheung, CFO

Thank you, Art. For the quarter ended June 30, net investment income was $0.27 per share. Looking at some of the expense categories, management fees totaled about $4.3 million. Taxes, general and administrative expenses totaled about $450,000 and interest expense totaled about $5.9 million. During the quarter ended June 30, net unrealized appreciation on investments was about $14 million or $0.37 per share. Net realized losses were about $13 million or $0.33 per share. And changes in the value of our credit facility and notes increased NAV by $0.08 per share. Net investment income was lower than a dividend by $0.02. Consequently, GAAP NAV went from $12.71 to $12.81 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.62 per share, up from $12.60 per share. Our entire portfolio, our credit facility, and mark-to-market are also evaluated by our Board of Directors each quarter using the exit price provided by an independent valuation firm, exchanges by an 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. We have ample liquidity and are prudently levered. Our GAAP debt to equity ratio was 1.1 times, while GAAP net debt to equity after subtracting cash was 1 time. The regulatory debt to equity ratio was 1.2 times and our regulatory net debt to equity ratio after subtracting cash was 1.1 times. With regard to leverage, we have been targeting a debt-to-equity range of up to 1.5 times. We have a strong capital structure with diversified funding sources and no near-term maturities. We have a $400 million revolving credit facility maturing in 2023 with $133 million drawn as of June 30. $118 million of unsecured senior notes maturing in 2023, $228 million of asset-backed debt associated with PennantPark CLO I due 2031, and $100 million of unsecured senior notes maturing in 2026. Our portfolio remains highly diversified with 100 companies across 42 different industries. 85% is invested in first lien senior secured debt, including 14% in PSSL. 2% in second lien debt, and 13% in equity, including 5% in PSSL. Our overall debt portfolio has a weighted average yield of 7.5%. 98% of the portfolio is floating rate and 82% of the portfolio has a LIBOR floor. The average LIBOR floor is 1%. Now, let me turn the call back to Art.

Arthur Penn, Chairman and CEO

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 a 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.

Operator, Operator

Thank you. And we'll now take our first question. It comes from Mickey Schleien from Ladenburg. Please go ahead.

Mickey Schleien, Analyst

Good morning, Art and welcome Richard. Art, this quarter I'm seeing mixed results in terms of the market opportunity, and I'd appreciate your insight. Clearly, the private debt and private equity markets have a lot of dry powder and spreads are tightening, which can result in a high level of repayments as we've seen at PFLT year-to-date. On the other hand, as you know, the economy is growing sharply and M&A is very active and I think borrowers also seem to be moving toward private debt solutions. I understand that repayments can be a function of vintage and call protection, but broadly speaking, I'd like to understand how you expect your portfolios across the Pennant platform to develop in the second half of this year and maybe going into next?

Arthur Penn, Chairman and CEO

Thanks, Mickey, and good morning. Quarter-to-date, repayments have been light and newer originations have been heavy. Last quarter, there were a lot of repayments. This quarter so far we've seen lighter repayment. We're seeing a lot of new companies come in. Sometimes there's the same more companies that get recycled and they go from one private equity firm to another, one private lender to another. This quarter, we're seeing many more new companies come into the system. Usually, and again, we're focused on kind of the $10 million to $50 million of EBITDA space as we have talked about. In many cases, the deals that we're doing, it’s the first time there's institutional capital in a founder-owned business or a family-owned business or entrepreneur, and the private equity sponsor is buying that company at first institutional capital, at first institutional equity, and we're the first institutional debt. So, we're kind of on the front lines of bringing new growing companies into the system. And over time, they may grow from $15 million of EBITDA to $50 or $60 million and they end up going off to the broadly syndicated market or going off to the big cat sponsors. But where we play and where we're getting our best returns is when those companies are starting out with $10 million to $20 million of EBITDA. The sponsor sees a fragmented industry or an organic growth opportunity. They're willing to plow a lot of equity behind it, which is great cushion for us. Our debt cannot fuel that growth; our equity co-invest can participate in the upside of that growth, and it ends up being a nice win-win. So this quarter, just to answer your question, we're seeing many more new companies come into the system versus the recycling of some very good older companies. For instance, we had an exit over PNNT and DecoPac. It's a great company. It went off to another sponsor and another direct lender, but the company has now grown bigger than when we started with it.

Mickey Schleien, Analyst

Thanks for that, Art. And that kind of leads into my next question in terms of the target market. Can you remind us what the average size of the borrower is in the PSSL portfolio compared to your own balance sheet portfolio and how would you compare the investment opportunities in those two segments?

Arthur Penn, Chairman and CEO

Well, PSSL is roughly similar to PFLT. PSSL gives us the ability to write a bigger check and solve a borrower problem, bringing some smart institutional capital like Kemper into our ecosystem, and also offering a higher ROE for PFLT shareholders. So, roughly the same portfolio just increases the wingspan, the bite size, and it's very accretive for PFLT shareholders. So, the average EBITDA is $25 million to $30 million in both vehicles. Now some of those were companies where we started out at $15 million or $20 million and they have grown. Some of those companies have started out at $30 million or $40 million. So, it's a blend of the two and the entire portfolio doesn't start out at $10 million or $20 million, but a chunk of it does and that tends to be the ones where those equity co-invest can be so valuable when we are hoping to fuel the growth of that company up to a bigger company where the sponsor sees a real opportunity for growth and is willing to plow substantial equity behind that opportunity. So blended, it is still $25 million to $30 million. Some are bigger companies from the get-go; some are smaller companies that have grown up.

Mickey Schleien, Analyst

And Art, can you remind us how you allocate between those two portfolios given that the borrowers are similar?

Arthur Penn, Chairman and CEO

Yeah. So, each portfolio has to stand on its own two feet and have proper diversification. So we want at least fifty names in each portfolio, which we have, and we want to be increasingly diversified. And that's a smart way to run a senior loan book, so they're both highly diversified portfolios. It is based on available capital. There's an available capital calculation. It's mathematical that when a deal gets done, there's a mathematical calculation that's done based on available capital.

Mickey Schleien, Analyst

Okay.

Arthur Penn, Chairman and CEO

And again, PFLT owns 87.5% in the joint venture. So, it's a pretty substantial ownership.

Mickey Schleien, Analyst

Right, in terms of the economics. Lastly, a housekeeping question, I don't know if it's for you or for Richard, but what was the main driver of your realized loss this quarter?

Arthur Penn, Chairman and CEO

We had an additional non-accrual from American Teleconferencing, also known as Premier Global, which resulted in an unrealized loss. The primary reason for the realized loss was Country Fresh, which had gone through bankruptcy and is no longer reflected on the balance sheet.

Mickey Schleien, Analyst

I understand.

Arthur Penn, Chairman and CEO

And that was the main driver of the realized loss.

Mickey Schleien, Analyst

I understand. That's it for me. Thanks for your time. And again, welcome Richard.

Richard Cheung, CFO

Thanks Mickey.

Operator, Operator

We'll now take our next question. It comes from Ryan Lynch of KBW. Please go ahead.

Ryan Lynch, Analyst

Hey, good morning. Thanks for taking my questions. The first one is kind of a follow-up to the previous question regarding the balance sheet in the PSSL. Because you mentioned the several goals for increasing operating earnings, increasing leverage, and increasing the portfolio size of PSSL. Well, on those first two goals, they're both kind of feeding off the same deal flow that kind of the platforms are bringing in. So, assuming that deals fit both of those strategies, which it sounds like they do, is there any preference to grow one versus the other, meaning add more balance sheet leverage versus trying to ramp up the PSSL, which is with the leverage within that fund, it's kind of a higher yielding entity? Is there any preference one over the other? I know they're both a goal but they kind of conflict with each other as far as the originations go where they can be placed?

Arthur Penn, Chairman and CEO

It's a complex question, Ryan, but I wouldn't say they conflict; rather, they complement each other. In terms of PFLT, our target leverage is up to 1.5 times, and we have to consider our credit ratings and some unsecured funds as well as market norms. The assets we manage in both PFLT and PSSL are also included in CLOs outside of our BDCs. If you examine the assets in PFLT and PSSL, they are among the lowest yield, lowest risk assets in the BDC space, and our expense load is relatively low. This allows us to manage these assets safely in a CLO format with three to four times debt-to-equity compared to what we have now, and we have managed them safely during COVID. Outside the BDCs, we can use a more leveraged approach. In PSSL, we would likely aim for a leverage ratio higher than 1.5 times debt to equity. The reason this could benefit PFLT is that in our joint ventures, we target leverage above 1.5 times. To clarify, our stated goal for the joint ventures is $750 million, or rather $730 million in total capital, with junior capital amounting to $275 million, which by definition means higher leverage.

Ryan Lynch, Analyst

Understood. And then as you guys are looking to deploy capital out in the market, certainly, overall market activity has increased, but obviously, competition has kind of resumed back to pre-COVID levels. I'm just curious, do you guys use any sort of macroeconomic backdrop as kind of a base case when you guys are underwriting these loans? Obviously, you guys are going to do a bottoms-up due diligence on each loan, but do you guys look at a loan today with same terms that alone may have had in 2018, 2019 as a better risk, a better proposition, just given that the economy today is kind of on an upswing from a credit cycle versus in 2018, 2019 we were 10 years from the last credit cycle? Does that inform your willingness to deploy capital in today's environment, obviously knowing that it's going to be ultimately a bottoms-up approach for credit, but do you guys use that macroeconomic backdrop to kind of inform how aggressive you'll be in today's market?

Arthur Penn, Chairman and CEO

Yeah, it's a good question and we do. I mean, just if you look back at the 2017 and 2019 time period, we were very public and others were too, that we were getting concerned that the cycle was getting long in the tooth. And there would be some sort of softness, of course, we never could have predicted COVID. But, I think a lot of us and we were public about it thought that we were getting late in the cycle and therefore operating in a more defensive posture. Today, we see it in our portfolio of companies; we get the monthly numbers, and the economy is in a strengthening position. Sometimes quite dramatically. So for sure, we feel more comfortable playing offense as a general macro matter today than we did say 2017 to 2019. That said, you're right, it's bottoms-up industry by industry specific. The companies that we're financing today all came through COVID in a very strong fashion. So, in many cases, they benefited from COVID. So we are playing a little bit more offensively; a little bit more of an offensive posture. And these are companies that we think are very high quality companies that we're prepared to back. One of the big lessons for us over all of our years in business, you got to find the right companies. You got to pick the right companies. And you can stretch a little bit of leverage. You might be able to be willing to stretch a little bit on yield. If you find the right companies, the rest of it takes care of itself, and that's the business we're in.

Ryan Lynch, Analyst

Yes, that makes sense. And then the last one that I had was, I know PFLT's equity portfolio is smaller than the PNNT, and I know PNNT had some cash proceeds. I was curious, did PFLT have any level of cash proceeds either from like dividends, dividend recapture or anything like that or actually exits this quarter, and what is your outlook as far as obviously that's one of your goals of equity rotation? What is your outlook on your ability to have meaningful equity exits over the next 12 months or so?

Arthur Penn, Chairman and CEO

Yes. That's a good question. So PFLT and PNNT are roughly the same investment size in Walker Edison. So last quarter, and we'll talk about it a little later, I mean, there were two capital events for Walker Edison in this past quarter. One was a dividend recap where two times we got back two times our money on the equity, and then there was an investment by Blackstone where we got another two times our investment. So that was a nice cash realization on Walker Edison that came our direction on equity. Just looking at the quarter, I mean, that was the big one. It was about a $4.3 million realized gain in the quarter. It was offset by Country Fresh. So the realization of the Country Fresh loss offset that; we had about a $1.4 million realized gain on DecoPac equity. And we had about a $700,000 gain on WBB equity. So some of the same names, different order of magnitude in PFLT. Going to the book itself and the equity co-invest there, you could see there's some that are performing very well based on the marks. Buy Right is one that we talked about a lot, that's about a $1 million market value there. We've got a company called Infosoft with about $5.7 million of equity, GCOM of over $4 million of equity. PFLT has $7.6 million of equity. There's still another $6.9 million of equity value in Walker Edison. So still some nice equity bites to be potentially exited and rotated over the coming year or two.

Ryan Lynch, Analyst

Okay, that’s helpful detail. I appreciate the time today.

Arthur Penn, Chairman and CEO

Thank you, Ryan.

Operator, Operator

We'll now take our next question. It comes from Devin Ryan of JMP Securities. Please go ahead.

Devin Ryan, Analyst

Great. Good morning, Art and Richard. Just a couple of follow-ups from us. I guess, the first one, the past couple of quarters you had I believe characterized the current vintage loans being the most attractive in the past decade or so. And I'm just curious if that's still the case today. I suspect that speaks to the strong originations and its posture, but how is the pipeline evolving, I guess more recently from an attractiveness perspective and is there any other color you can share around that?

Richard Cheung, CFO

Yes, it's a good question, Devin. The best thing about the vintage is, again, the companies that we're financing today came through COVID in really good shape and in some cases strengthened through COVID. So, we're in the credit selection business. We have to pick good credits. We have to avoid mistakes. So the quality of the company is paramount, and that's the most attractive thing is we're seeing companies that have come through the last couple of years of chaos and uncertainty with a strong posture, which gives us confidence that our capital will be preserved and in some cases with the equity co-invest beginning we will be increasing value through these equity co-invest. So, that's really the most attractive thing. And look, the deal machinery was put on hold for a year and half, right? There were no deals, or very little deals. So, all of this pent-up deal demand is kind of coming to fruition today, and that's one of the things driving it. We also think there's a piece of it that's potentially focused around the potential capital gains increase sometime in the future and a desire by some sellers to capture a gain before a potential capital gain increase. So I think that's playing into it a little bit, kind of the pent-up demand from the past year and a half and the potential capital gains increase on the horizon are both working together to bring a lot of deals.

Devin Ryan, Analyst

Yes, okay great. That makes a lot of sense. Thank you. And then just follow-up on one of your prior comments just about recent repayment activity slowing. I know it's episodic, but do you see any trend there around that, and are there any of the factors that you see shifting?

Richard Cheung, CFO

Yes, we could be seeing more new names in our ecosystem. The repayments and refinancings are typically with companies already in the ecosystem. It’s an opportunistic market with companies being sold or refinanced. As we bring new companies into this space, they could start with $10 million or $20 million of EBITDA, and in three years, they might grow to $50 million, potentially moving on to larger lenders or private equity firms. We're observing an increase in new names entering the middle-market direct lending ecosystem. Many of these companies are seeking their first institutional capital from families or entrepreneurs who have built their businesses over many years and are now selling to private equity firms. These businesses may generate $10 million to $25 million of EBITDA, and it's their first encounter with institutional capital. The private equity firms then introduce various financial processes and controls aimed at scaling these companies from $15 million or $20 million to $40 million, $50 million, or even $70 million. We act as the first private debt lenders for these companies, and our debt contributes to their growth. We’ve co-invested in the equity and share in the potential upside while providing the necessary debt capital. I believe we're seeing significantly more new names this quarter compared to last, which was mostly about refinancing existing names. While some of the established names are excellent, we're excited about the new entrants.

Devin Ryan, Analyst

Yes. Okay, terrific. Yeah. I appreciate it. A little of a crystal ball question, but that's great color. So I'll leave it there. Thank you.

Operator, Operator

This concludes our question-and-answer session. I'd now like to hand the call back to Mr. Art Penn for any additional comments or closing remarks.

Arthur Penn, Chairman and CEO

I wanted to just thank everybody for their participation today in the call, and our next call will be in November. It's our 10-K so it will be slightly later in the quarter than our normal Qs, but kind of mid-November timeframe we will have our next quarterly conference call. In the meantime, I hope everybody has a great and safe summer. Thank you very much.

Operator, Operator

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