Pennantpark Investment Corp Q4 FY2022 Earnings Call

Good afternoon, and welcome to the PennantPark Investment Corporation's Fourth Fiscal Quarter 2022 Earnings Conference Call. Today's conference is being recorded. At this time, all participants have been placed in a listen-only mode. The call will be open for questions-and-answers session following the speakers remarks. Thank you. It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Mr. Penn, you may begin your conference.

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation'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.

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 Investment Corporation 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.

Thanks, Rick. We're going to spend a few minutes and comment on our target market environment, provide a summary of how we fared in the quarter ended September 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open up for Q&A. From an overall perspective in this market environment of inflation, rising interest rates, geopolitical risk and a potentially weakening economy, we are well-positioned as a lender focused on capital preservation in the United States where the floating interest rates on our loans can protect against rising interest rates and inflation. We continue to believe that our focus on the core middle market provides important attractive investment opportunities where we are important strategic capital to our borrowers. In times of market volatility, our opportunistic credit strategy focuses on creating value from the dislocation in the markets. Specifically, we've been active buying first lien loans in the secondary market at discounts in companies where we have differentiated institutional knowledge. It could be a company that we used to finance in a sector where we have domain expertise or a direct relationship with the management team or financial sponsor. We've been buying loans where we think we can generate double-digit or low-teens IRRs as the loans return to par in three years. We employed a similar strategy during the global financial crisis and generated excellent returns. In prior quarters, we outlined a game plan for growth of net investment income and dividends. We continue to execute on our plan to increase long-term shareholder value, and I'm pleased to announce that the Board of Directors has approved another increase of our quarterly dividend of $0.165 per share payable on January 3rd to shareholders of record as of December 19th. Additionally during the September quarter end, we continued buying shares under our stock buyback program and purchased approximately 189,000 shares during the quarter for $1.2 million. In total, we have bought back $13.2 million of shares or 1.8 million shares. Some highlights for the quarter ended September 30th were as follows; our debt portfolio continues to benefit from rising base rates. Our weighted average yield to maturity increased to 10.8% from 9.3% last quarter. Approximately 96% of our assets are floating rate compared to 47% of our liabilities that are fixed rate. Holding everything else constant, every 100 basis point increase in base rates translates into approximately $0.02 per share of net investment income. Another highlight was that our portfolio performed well during the quarter and we did not put any new investments on non-accrual. As of September 30th, we have one non-accrual, which represents 1% of the portfolio cost and 0% at market value. Thirdly, during the quarter we completed the amendment extension and expansion of the Truist Credit Facility. The size increased from $465 million to $500 million and the maturity was extended three years until 2027. Thank you to our lending partners for their confidence and support of the company. And fourth, we continue to grow our PSLF joint venture. The joint venture grew from $608 million to $730 million during the quarter and continues to generate an attractive double-digit ROE for PNNT. We are targeting a $1 billion vehicle over time where we can drive substantial growth in net investment income at PNNT. 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 original issue discount are higher, covenants are tighter and loan-to-value continue to be attractive. Our capital, which we believe is always value added is adding even more value in this environment. For the quarter ended September 30th, we invested $134 million in new and existing portfolio companies and had sales and repayments of $176 million. Now to review the operating results. For the quarter ended September 30th, core net investment income was $0.18 per share, including $0.01 per share of other income. This excludes one-time upfront financing costs from the amendment and extension of our credit facility. Our NAV was down due primarily to unrealized mark-to-market adjustments in our portfolio tied to the overall market and not due to fundamental credit factors. As you might expect most of the mark-to-market volatility came from our equity portfolio. Overall, GAAP NAV decreased by 6.9% comprised of a 3.6% decrease due to the fair value adjustments on our equity holdings and a 2.5% decrease due to the fair value adjustments on our debt holdings. The remaining 1% was attributed to fair value adjustments on our credit facilities. With regard to increasing net investment income, our strategy remains focused on: number one, optimizing the portfolio and balance sheet of PNNT as we move towards our target leverage ratio of 1.25x debt to equity; number two, growing our PSLF joint venture with Pantheon to $1 billion of assets from approximately $730 million of assets at quarter end; and number three, rotating out of our equity investments over time and redeploying the capital into cash pay yield instruments. We have a long-term track record of generating value by successfully financing high-growth middle market companies in five key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask and have an excellent track record. These sectors include business services, consumer, government services and defense, healthcare, and software technology. These sectors have also 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 and technology investments. In many cases, we are typically part of the first institutional capital into a company or a founder, entrepreneur, or family 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 a 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 2.5 times. With the current volatility in the broadly syndicated 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're an important strategic lending partner, the process and packaging terms that 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 upfront fees and spreads, and an 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, 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 were so strong and why we believe we're 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 a 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 is a perception and 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 and 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 performing well and we believe we're well-positioned for future quarters. As of September 30, the weighted average debt-to-EBITDA on the portfolio was 4.6 times and the average interest coverage ratio, the amount of which cash interest exceeds cash interest expense, was 3.6 times. This provides significant cushion to support stable investment income even when interest rates rise; based on this substantial cushion, even with the 200 basis point rise in base rates, and flat EBITDA, our portfolio companies will cover their interest 2.3 times on average. Since inception, PNNT has invested $7.3 billion at an average yield of 11%. This compares to a loss ratio of approximately 9 basis points annually. This strong track record includes our energy investments, our primarily subordinated debt investments made prior to the financial crisis, and recently the pandemic. With regard to the outlook, our new loans and our target market are attractive and this vintage should be particularly attractive. 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. We want to reiterate our mission, our goal to generate attractive risk-adjusted returns through income, coupled with long-term 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 through debt 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.

Thank you, Art. For the quarter ended September 30, net investment income totaled $0.14 per share including $0.01 per share of other income. Operating expenses for the quarter were as follows: base management fees were $4.9 million. Interest and credit facility expenses were $13.7 million. General and administrative expenses were $1 million and provision for taxes was $200,000. During the quarter, we expensed $5.1 million of credit facility expenses related to the amendment and extension of our revolving credit facility. Excluding the $5.1 million of credit facility expenses, core net investment income was $0.18 per share. For the quarter ended September 30, net realized and unrealized change on investments and debt including provision for taxes was a loss of $44.1 million or $0.68 per share. The reversal of the provision for taxes of $7.2 million or $0.11 per share was due primarily to the decrease in the value of RAM Energy. Change in the value of our credit facility decreased our NAV by $0.08 per share. Core net investment income exceeded the dividend by $0.015 per share. As of September 30, our NAV per share was $8.98, which is down 6.9% from $9.65 per share from the prior quarter. Our GAAP debt-to-equity ratio net of cash was 1.2 times. As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 123 companies across 32 different industries. The portfolio was invested 51% in first lien secured debt, 11% in second lien secured debt, 12% in subordinated debt, including 7% in PSLF, and 26% in preferred and common equity, including 4% in PSLF. The weighted average yield on debt investments was 10.8%. Ninety-six percent of the debt portfolio is floating rate with an average LIBOR floor of 1%. As base interest rates rise, we are well-positioned to participate on the upside. Holding everything else constant in the portfolio, a 1% increase in base rates translates into approximately $0.02 per share of net investment income upside per quarter. As of September 30, 2022, the company had approximately $0.71 per share of spillover taxable income. Now, let me turn the call back to Art.

Thanks, Rick. In closing, I'd like to thank our dedicated and talented team of professionals for their continued commitment to PNNT and its shareholders. Thank you all for your time today and for your continued investment and confidence in us. That concludes our remarks. At this time, I'd like to open up the call to questions.

We'll take our first question from Casey Alexander with Compass Point. Please go ahead.

Yeah. Hi. Can you hear me?

Yes. We can. Thanks, Casey.

My first question is about your ability to purchase first lien loans in the secondary market. Are these new relationships, or are you acquiring pieces of loans you already hold? Can you provide a breakdown? Additionally, what percentage of your new originations this quarter resulted from buying first lien loans in the secondary market compared to direct origination?

Thanks, Casey. These are typically loans, where we feel like we have a differentiated viewpoint, where we're not buying the market. It's typically a company we might have financed when it was a little smaller in the core middle market and may have graduated to the broadly syndicated loan market. It's in industries where we think we have domain expertise. We know the management, we know the sponsor, and where we think we're buying $1 for between $0.85 and $0.95. And we think there’ll be a potential pull to par over a two or three year time period, which gets you kind of the low to mid-teens kind of IRR. So all first lien to secure all credits that we feel are strong credits with good cash flow. It just happened to be a little bit of the baby's gone out with the bathwater in a choppy market environment that we’ve had. It’s been primarily more recently that we did a little bit in the quarter ended September 30. It's certainly a big piece of what we're doing in the quarter that we're in today.

Would you characterize these as broadly syndicated loans or are these private debt loans that are put out by private debt lenders?

No, these are loans where we can access in the broadly syndicated loan market. They trade with the big broker-dealers. And given the market environment they're at a discount. So in virtually, we think we have a different info hedged, but the BSL that in many cases graduated from middle market over time.

Right. Okay. Thank you for that. Secondly, can you explain why PennantPark takes the $5 million amend and extend fee upfront when most platforms amortize that over the life of the credit facility? And if you'd like to make a case why that's better for investors, I would love to hear it.

The upfront fee can be handled in a couple of ways. From an accounting perspective, we are required to record it as a one-time expense due to how we manage our credit facility, rather than spreading it out over the duration of the loan. This means we absorb the cost now, but we avoid incurring additional expenses throughout the loan period. This quarter, it also means that management does not earn an incentive fee, which is favorable for shareholders. Historically, during the global financial crisis, we chose to align our liabilities with market values, which helped with the SEC's asset coverage ratio, although we're still managing the effects of that decision. The SEC prefers that we do not continue that practice, and we share that preference. Nowadays, these credit facilities are closer to their actual value; however, we must account for the one-time fee because the credit facility we keep modifying is fundamentally the same as the one we've used for many years, with the same lenders and lead lender, and only the extension terms have changed. Therefore, we have to recognize it as a one-time expense in this quarter. We also clarify the distinction between core and non-core items in our net investment income report.

Okay. Thank you for that. And lastly...

Is that clear?

It seems clearer to me than it does to most, but I believe it's a very good answer. That was very helpful. Lastly, on …

Okay.

Walker Edison you marked that similar to where you actually have a partner in that loan that also marked. And Walker Edison has been a company that has given PennantPark substantial benefits in the past. Do you want to kind of go through the history of that where you stand with that loan today what you think is going to happen? And there's also another big private equity shop that is actually behind you on that that might be helping you drive a positive outcome there? So I would love to hear your thoughts on that one.

Yeah. So Walker Edison was a company that we financed, we say five, six years ago. It's a company that is in the furniture business and their distribution channel is Wayfair, Amazon. It's an e-commerce distribution channel. We get a loan to the company. We took an equity co-invest five, six years ago. It did very, very, very well. COVID accelerated things. I think our equity co-investment we had a four times multiple on invested capital in cash. To-date, about a year, 1.5 years ago, a division of a large private equity sponsor Blackstone put $250 million of junior capital into the company. We rolled into a new debt piece with other partners in the direct lending industry. And we felt it was a safe loan, obviously at that point – in that point in time. Otherwise, we would have done it kind of enhanced by the equity cushion by the large private equity sponsor. Companies massively underperformed since then. The post-COVID world is different and this company in and of their own right did not manage that well. So they did pay us cash interest as of 9/30. So we've leave the 9/30 quarter kept it on hold. Obviously, all bets are off for the 12/31 quarter and we'll see what happens between now and then. There are restructuring conversations going on as we speak. And I think that's probably all I can report at this point in time.

Great. Thank you very much for that answer and that’s all my questions. I appreciate. Thanks, Art.

Thanks, Casey.

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

Hey, good afternoon, guys. Thanks for taking my questions. First one, I just was hoping to understand the mark on RAM Energy a little bit more this quarter and kind of what drove that markdown? I understand you guys have taken a very patient approach to turnarounds in the past. And there's a lot of moving pieces that potentially go into the valuation here as you guys are evaluating strategic alternatives. But one of the things I look at – I mean I'm looking just in the public market comps for E&P companies, the XOP, up 6.5% in the quarter. I know oil prices were down in the quarter about 25% or so. RAM Energy I think this quarter you guys marked about 32% lower but a lot of the public comps for energy companies specifically the E&P sector are obviously up. So I'm wondering if it's anything that's going on fundamentally with the operations of the company that would cause you guys to mark the investment down, or is it related to the strategic alternative exploration process, where potentially maybe you've seen lower offers than the valuation in Q2? But anything that you can say would be helpful.

Thanks Paul. And we do have to be very careful as the company is exploring strategic options, so somewhat limited in really answering the question Paul, other than to say many factors go into valuation. The price of oil and gas between June 30 and September 30 was down quite substantially and that was one of the factors that went into the valuation.

I understand that you can't provide too much information. However, taking a step back from the investment perspective, I'm curious if this has ever become a strain on resources. With faculty and employees dedicating their time and efforts to turning this around, does it start to disrupt your typical investment process?

Yes. So Paul, just a clarification on your prior question. Just to be clear RAM is performing well. There's no operational issues. There's nothing new or different on RAM. It's a performing company that's doing well and is healthy. On the time resource question, look we may have a different attitude than some of our peers. We get paid to maximize value. And that's, what we do. And if it takes time and resources, we’ll do whatever is in the best interest of the shareholder. That's what we get paid to do, to try to get the best outcome possible. Sometimes that means full-blown restructurings, a pivot was a recent example where there was a conversion of debt to equity. We took control. We became a sponsor. We changed management. we dealt with all the various tranches of loans, and we worked with the company to turn around the operations and we were fortunate enough to exit at, a very high price at a really, really good time in hindsight. And RAM is another one; we've been longer than pivot obviously. Our view is, this is what we do. And if it takes time and resources, it takes time and resource that's our job.

Thanks. I appreciate it. And then just on the secondary purchases you guys made this quarter. Just curious obviously, you saw good value and you're using your informational and expertise advantage there to potentially make some par trades. But I'm just curious, how you evaluate? I guess those trades. I mean, are these secondary purchases supplementing potentially depressed deal flow or deal volume in the third and fourth quarter of this year, or are these just very advantageous trades that happened to become available that you felt were good investments for the BDC?

Yes, each investment needs to stand on its own two feet. We do though compare and contrast and say 'Okay, we can put $1 to work at $0.90 on the dollar or we can do this new loan or we can do both.' How do we look at it? So, we're looking at it through the lens of, we do not advance any capital, we have plenty of capital, but we do not advance any capital. So we do compare and contrast and debate and really try to through our investment committee, find the best risk-adjusted returns that we can whether they be in the primary market or the secondary market, and do our best to synthesize all that and allocate capital as best we can.

Thanks. And I mean would you consider those investments to be pulled to maturity type investments that you're planning on holding to maturity, or are these kind of more held for trading, where if there's any kind of recovery to par, you'd be looking to exit?

Sure. So, when you're dealing with more liquid investments, like those, if they were to kind of trade from 90 to par, we could say, okay, we could sell this loan at par. We have a new primary middle market loan. We can do and question what's the best risk-adjusted return? In most cases, if these loans get pulled to par, which we hope they do, we would trade out of them and reallocate the money into core middle market originations.

Got it. Thanks. That makes sense. My last question is about your equity co-investment strategy. I'm curious since this has been a significant part of your approach from the beginning. When you enter a deal, do you typically have the option for equity co-investment instead of fees or original issue discount? Do you have a choice between these options like exit fees or OID? If so, when you're assessing the options, do you have a preference for either one? I'm thinking of a time like now when you're looking to reduce equity exposure in the portfolio. Is this something you have moved away from, or is it still a regular aspect of the investment process?

Yes, in general, since many of our deals are kind of buy and build and our debt capital is strategic capital to make that buy and build happen. We feel as though in general, if we believe in the growth of the company, having some form of equity participation makes sense for the debt, because after all, we're helping to drive that value. We should or why wouldn't we have some participation in that upside? So by and large, it is something we do and may be a differentiator versus some of our peers. I think, it's particularly important in the buy-and-build growth types of deals, which is primarily what we're doing these days, right? So, it is important. Rarely is it a trade-off; hey you can get the co-invest if you take less yield or you take less OID, usually it's just kind of baked in and part of the understanding that we have with the private equity sponsor, that this is how we do business and it's not a trade-off situation. In certain cases, they want to limit us or not let us have it in which case we sometimes were like okay, the debt is so good. We don't need the equity. In some cases we're kind of like, okay, the equity is not that attractive. That's fine. In other cases, it may be a situation where we walk from the deal because we think the equity is a really important part of our package. So we try to look at each deal in each part of the capital structure on their own two feet, such that in some cases the debt is really good. We may not be so excited about the equity and that's fine. In other cases, we may be really excited about the equity and try to get more. So, case by case, each piece of the capital structure needs to stand on its own two feet, but rarely is it kind of a trade-off scenario.

Got it. Appreciate it. Very interesting and that’s all from me.

Ladies and gentlemen, this concludes today's question-and-answer session. At this time, I'd like to turn the conference back to Mr. Art Penn for closing remarks.

Thank you, everybody. Wishing everybody a terrific Thanksgiving full of gratitude. Terrific holiday season and we'll be talking to you next in early February for December 31 earnings. Thank you very much.

Ladies and gentlemen, this concludes today's conference. We appreciate your participation. You may now disconnect.