Earnings Call Transcript - PFLT Q2 2024

Operator, Operator

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

Arthur Penn, Chairman and CEO

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Second 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 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, 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 March 31, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, and then open it up for Q&A. For the quarter ended March 31, GAAP and core net investment income was $0.31 per share. GAAP and adjusted NAV increased 1.8% to $11.40 per share from $11.20 per share. The increase in NAV for the quarter was due primarily to positive valuation adjustments on both debt and equity investments. As of March 31, our portfolio grew to $1.5 billion or up 16% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities and invested $338 million in 11 new and 48 existing portfolio companies at a weighted average yield of 11.6%. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 4.2x. The weighted average interest coverage was 2.1x and the weighted average loan to value was 42%. On average, we have seen a 50 basis point tightening on first lien spreads over the last 6 months. However, we continue to believe that the current vintage of core middle market directly originated loans is excellent. In the core middle market, leverage is lower, spreads and 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. As of March 31, our debt-to-equity ratio was 1.2:1 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. Securitization financing continues to be a good match for our lower risk first lien assets. During the quarter, PFLT closed a $351 million term debt securitization transaction with a weighted average spread of 2.79%, a 4-year reinvestment period, and a 12-year final maturity. The AAA portion of the structure priced at a weighted average spread of 2.3%. The ratio of external debt to PFLT's junior capital was 4.5:1 which creates plenty of liquidity for the company. The proceeds were used to repay a portion of our senior secured revolving facility, which will be available to reborrow and invest in new originations as we continue to grow the PFLT portfolio. We expect additional growth in NII in part driven by our investment in the joint venture. As of March 31, the JV portfolio totaled $870 million and 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 $80 million in 6 new and 4 existing portfolio companies that had a weighted average yield of 11.6%, including $77 million of assets purchased from PFLT. We believe that the increase in scale of the JV's balance sheet will continue to drive an attractive mid-teens return on invested capital and enhance PFLT's earnings momentum. Credit quality of the portfolio has remained strong. We added 1 new investment to nonaccrual status and removed 1 investment. Nonaccruals represent only 0.4% of the portfolio at cost and 0.3% at market value. For the quarter ended March 31, PIK income remained low at only 1.7% of total investment income, which we believe is among the lowest in the BDC sector. As of March 31, the portfolio's weighted average leverage ratio through our debt security was 4.4x, and the portfolio's weighted average interest coverage was 2.2x. We believe that this is one of the most conservatively structured portfolios in the direct lending industry and is a testament to our focus on the core middle market. 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. We 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 19% 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. In the core middle market, which we define as companies with $10 million to $50 million of EBITDA, that is below the threshold and does not compete with a broadly syndicated loan market or the 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 is attractive. We have many weeks to do our due diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, attractive 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 have 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 $5.9 billion in 492 companies and we have experienced only 18 nonaccruals. Since inception, PFLT's loss ratio on invested capital is only 12 basis points 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 March 31, we have invested over $469 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 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 March 31, GAAP and core net investment income was $0.31 per share. Operating expenses for the quarter were as follows: interest and expenses on debt were $14.7 million. Base management and performance-based incentive fees were $8.2 million. General and administrative expenses were $1.8 million and provision for taxes were $0.5 million. For the quarter ended March 31, net realized and unrealized change on investments, including provision for taxes, was a gain of $12 million or $0.20 per share. As of March 31, our GAAP NAV was $11.40, which is up 1.8% from $11.20 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.40 per share, up 1.8% from $11.20 per share last quarter. As of March 31, our debt-to-equity ratio was 1.2x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of March 31, our key portfolio statistics were as follows: Our portfolio remains highly diversified with 146 companies across 44 different industries. The weighted average yield on our debt investments was 12.3% and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 1.7% of total investment income. We had 1 nonaccrual, which represents 0.4% of the portfolio at cost and 0.3% at market value. The portfolio is comprised of 87% first lien senior secured debt, less than 1% in second lien and subordinated debt, 6% in equity of PSSL, and 7% in other equity. Debt to EBITDA on the portfolio is 4.4x and interest coverage was 2.2x. Now let me turn the call back to Art.

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.

Operator, Operator

At this time, I would like to open up the call to questions.

Brian McKenna, Analyst

So it's great to see all the growth in the investment portfolio year-to-date, up nearly 40% over the past 2 quarters. Leverage, as you mentioned, is still below your 1.5x target. So how should we think about growth of the portfolio from here? And then how does all this growth ultimately impact the trajectory of NII over the next few quarters?

Arthur Penn, Chairman and CEO

Thanks, Brian. It's a good question. Look, our belief is that the back half of 2024 is going to be active. So we think we're going to be able to be very active to deploy really good capital at this good vintage with these credit statistics. So we're hoping that come the turn of the year turning into 2025, we will be pretty close to our target leverage.

Brian McKenna, Analyst

Yes. Got it. Okay. Makes sense. And then just a follow-up. In the quarter, you invested in 11 new portfolio companies, 48 existing portfolio companies, now at an average weighted yield of 11.6%. So a couple of questions here. How much did average yields come in relative to the last couple of quarters for new investments? Can you give any color on quarter-to-date spreads or yields? I know you mentioned kind of tightening of 50 basis points. Has that trended differently over the last several weeks here? And then moving forward, just on deployment, how should we think about the mix of new investments versus existing portfolio company investments?

Arthur Penn, Chairman and CEO

Yes. Yes, spreads over the last 6 to 9 months have come in on average about 50%. So what was a SOFR plus 600 is more like a SOFR 550 right now. We think that's kind of meeting its low. We do believe there's a chance that spreads could widen again, particularly if there's a lot of supply, as there seems to be a lot of activity coming into the end of '24, which we believe there will be given supply-demand, so there's a chance that spreads may widen. We don't underwrite that. You shouldn't underwrite that, but that's certainly a possibility. We think at this point they've reached their minimum. In terms of kind of new platforms versus existing, we have over 100 companies in the portfolio, most of which are growing companies that need additional capital. We add value to those borrowers and private equity sponsors by being a strategic lender to help them grow and provide additional capital to fuel that growth. So even in quarters with fewer new platform activities, we are busy with the existing portfolio and financing them.

Operator, Operator

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

Mark Hughes, Analyst

Your outlook for spreads potentially widening, as you say, don't take it to the bank, but it's an idea. Is that supply and demand? Is that because you think there will be a lot of opportunities coming to market? And that will benefit you all? Or do you think there's some additional risk that may be coming later in the year? How do you see that?

Arthur Penn, Chairman and CEO

Yes. It’s a good question. My comments were more focused on supply-demand of deal flow. We think there's going to be a lot of deal flow in the back half of '24, that's where that comes from. It doesn't come from any projection about the health of the economy. We underwrite our scenarios as lenders assuming there is a soft economic environment early on in the deal. Whether there is one or not, we have no idea. No one really does, but we assume that, which is why we generally structure these loans conservatively with low leverage, high equity cushion, good covenants, and good information rights believing that there may be a bump at some point.

Mark Hughes, Analyst

Understood. And then the positive valuation marks in the quarter helped to drive up NAV. Any detail you can provide on whether that's equity performance or broader capital market movements influencing that? I would be curious if any breakout or detail.

Arthur Penn, Chairman and CEO

Yes, it's a combination of both. Some of the equity investments by Comvest did particularly well, especially with a company called Marketplace Events. These two were the primary contributors to the increase in equity value. There's also been a significant movement in the debt securities portfolio. As we've mentioned, we believe that spreads have tightened by about 50 basis points over the past 6 to 9 months, which is reflected in the overall increases in the valuations of the debt securities.

Mark Hughes, Analyst

What is your broader general credit outlook from a macro perspective as we think about going through 2024? Do you have any particular views on where things might be heading?

Arthur Penn, Chairman and CEO

Not really. We're not macroeconomists. We are micro credit underwriters. For lenders, it's fine if you've underwritten credit appropriately. We underwrite assuming there will be some bumps in the road early in the life of a loan. So we believe we're well positioned in any environment. However, we don't have any insights for macro calls; I'm sure others have some expertise, but that's not really our strength.

Operator, Operator

We will now move to Vilas Abraham from UBS.

Vilas Abraham, Analyst

Can you talk a little bit about the timing of the liability actions PFLT took in Q1? And just how we should think about the average cost of debt trend into Q2?

Arthur Penn, Chairman and CEO

It's a great question. We've been talking about spread tightening and things moving in a positive direction. Our securitization occurred in early February. Spreads on CLOs have come down since then. I think we said we were about 230 over on the AAA on the PFLT securitization. We just priced a AAA for the JV. PFLT owns 87.5% of the JV with Kemper, and we just priced the AAAs around 193. We're going to get the benefit of some tightening that happened between early February and now. We like the securitization financing. Again, we just know that it matches well for our lower risk first lien assets. It's a 12-year maturity, matched from a fixed standpoint. The structure of the securitizations is such that we never have to worry about a credit officer having a bad day; they are very self-correcting. We operated a middle market CLO through COVID, and it worked wonderfully during that period. So we really like the securitization structure.

Vilas Abraham, Analyst

Okay. All right. And then just on the amendment activity, can you comment on what you're seeing there? So other income was a little elevated again in Q1. Just thinking about how we should look at that moving forward.

Arthur Penn, Chairman and CEO

Yes. Look, the amendments are part of our business. They always are. It's not that material at this point. There are a handful of names that tend to amend every quarter, some are bigger, some are smaller. I think we've seen that the loan-to-value is very attractive. In many cases, we ask the private equity sponsors to inject additional equity under us as part of an amendment, and they do. Going back to COVID, in almost every case, the sponsors put equity in to solve the problem. That's what happens when you have well-structured covenants that have meaning, versus what’s happening in the upper middle market. In the core middle market, we observe covenants, which get us to the table and create that opportunity to ask for more equity or to ask for additional benefits, whether those are fees or increased spread. So having the monthly financial statements and quarterly maintenance tests and covenants has been beneficial for us over time, most importantly for protecting and preserving capital. Of course, we make mistakes; we all do. But we really try to minimize them through our structures.

Operator, Operator

We will take our next question from Joe Martin from Columbus.

Unknown Analyst, Analyst

If you can, can you just give some background on the new nonaccrual and the 1 nonaccrual that came off?

Arthur Penn, Chairman and CEO

Sure. Thank you. The nonaccrual that came off is a company called MailSouth or MSpark, which was the name listed in our scheduled investments, but it changed to MSpark. We had already marked that down to 0 in the previous quarters. So that was just because the company was sold, and in fact, we recovered 0. The one that moved on to nonaccrual is a company called Walker Edison. Walker Edison underwent a restructuring a while back. It continues to not perform well. We're optimistic though; we believe the sector will heal over time, but it's taking a while. So we proactively put that company on nonaccrual.

Unknown Analyst, Analyst

And a follow-up. Moody's came out yesterday with a report regarding how middle-market CLOs, the smaller companies were more affected with higher rates. Just wondering if you could comment on that, Art.

Arthur Penn, Chairman and CEO

It's no surprise that higher rates have an impact. When people did these deals originally, no one anticipated the risk-free rate would reach where it is now. On average, our companies are still covering at over 2x. So that’s really a testament to how we structure the deals conservatively. Most of these deals were done prior to the interest rate increases when the coverage was over 3x, but it's now around 2x, which is expected. Still, we've seen very few nonaccruals and light amendment activity, which highlights the strength of our core middle market. We have a playing field where leverage is lower, and our capital is meaningful to these borrowers.

Unknown Analyst, Analyst

The fund is doing well and the metrics are very good. Have you considered talking to Moody's or S&P or Fitch to get another rating?

Arthur Penn, Chairman and CEO

Yes. It's interesting. S&P rates our CLOs and gives us rating estimates for all the loans in our CLOs. Our senior loans are rated by S&P, and when we approach them for securitization, they say that the top 65% can be rated AAA. We just issued AAA at 193 recently in the JV. Essentially, when leveraging the assets 2x, they usually give us a AAA rating. However, when we walk into what they call a BDC, the leverage threshold is much lower, about 1.25x. There’s a bit of inconsistency going on at S&P regarding how they evaluate the same credits whether through securitization or at the BDC level. We're happy to discuss this further with them.

Operator, Operator

Art, I'd like to turn the conference back to you for any additional or closing remarks.

Arthur Penn, Chairman and CEO

Thank you. I just want to thank everybody for being on the call today. Next time we will talk will be after our June quarterly earnings, which will be in early August. In the meantime, wishing everybody a great spring and summer. Have a good day.

Operator, Operator

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