Pennantpark Investment Corp Q3 FY2023 Earnings Call

Good afternoon, and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2023 Earnings Conference Call. Today's conference is being recorded. At this time, all participants are in a listen-only mode. 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 third fiscal quarter 2023 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 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 commenting on the current market environment for private credit, provide a summary of how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, followed by a detailed review of the financials, then open it up for Q&A. For the quarter ended June 30, our net investment income was $0.35 per share. Core NII was $0.22 per share and excludes $0.13 of one-time dividend income related to our equity investment in Dominion Voting. GAAP NAV increased 1.6% to $7.72 per share from $7.60 per share. The increase was driven largely by stable portfolio valuations and the dividend from Dominion. Adjusted NAV increased 3.1% to $7.67 per share from $7.44. The debt portfolio continues to benefit from the increase in base rates. As of June 30, our weighted average yield to maturity was 12.7%, which is up from 12.1% last quarter and 9.3% last year. During the quarter, we continued to originate attractive investment opportunities and invested $70 million in new and existing portfolio companies at a weighted average yield of 12.6%. For the investments in new portfolio companies, the weighted average debt to EBITDA was 4.1 times. The weighted average interest coverage was 2.1 times, and the weighted average loan to value was 36%. We continue to believe that the current vintage of middle market directly originated loans is excellent. Leverage is lower, spreads and upfront fees are higher, and covenants are tighter. We are seeing an increase in deal flow compared to the first half of 2023 and have a growing pipeline of interesting and attractive investment opportunities. Additional capital we are raising across the PennantPark platform will allow PNNT and the Joint Venture to capitalize on the attractive lending environment. At June 30, the Joint Venture portfolio equaled $794 million, and during the quarter, the Joint Venture invested $64 million, including $62 million of purchases from PNNT. After quarter-end, the Joint Venture closed a $300 million securitization. This new financing, together with the existing committed junior capital from PNNT and Pantheon, will allow the Joint Venture portfolio to grow to over $1 billion in assets. Over the last 12 months, PNNT earned a 17% return on invested capital in the Joint Venture. We expect that with the continued growth in the Joint Venture portfolio, the Joint Venture investment will enhance PNNT's earnings momentum in future quarters. Credit quality of the portfolio continues to perform well. As of June 30, we had one non-accrual out of 129 different names at PNNT. This represents 1.1% of the portfolio at cost and 0% at market value. As a result of a stable debt portfolio and the growing net investment income, the Board of Directors has approved another increase in the quarterly dividend to $0.21 per share. This increase is the seventh consecutive increase in the quarterly dividend and represents a 5% increase from the prior quarter and a cumulative increase of 75% from January 2022. The dividend will be paid on October 2 to shareholders of record as of September 18. We are confident that with rising or stable base rates and continued strong credit performance, the increased dividend will be fully covered by core net investment income. We believe that a portion of the investment community values a monthly dividend. As a result, the Board has also decided to change the frequency of the dividend from quarterly to monthly. This change will be implemented in October. Now let me turn to the current market environment. 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 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 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 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. They are: business services, consumer, government services and defense, healthcare, and software and technology. These sectors have also been recession resilient and tend to generate strong free cash flow. In our software vertical, we don't have any exposure to ARR loans. In many cases, we are typically part of the first institutional capital into a company, and the loans that we provide are important strategic capital that fuels growth and helps 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, from inception through June 30, we have invested over $403 million in equity co-invests and have generated an IRR of 26% and a multiple on invested capital of 2.2 times. Because we are an important strategic lending partner, the process and package of returns we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushion to protect our capital, attractive upfront fees and spreads, and equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, virtually all of our originated first lien loans had 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 are well-positioned in this environment. This sector of the market, companies with $10 million to $50 million of EBITDA, is the core middle market. The core middle market is below the threshold and does not compete with broadly syndicated loans or high-yield markets. Many of our peers who focus on the upper middle market state that those larger companies are less risky; that is a perception. It 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 fall rate and a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of the core middle market, where there's more careful diligence and tighter monitoring, have been an important part of this differentiated performance. Since inception, PNNT has invested $7.5 billion at an average yield of 11.2% and has experienced a loss ratio of approximately 20 basis points annually. This strong track record includes our energy investments, primarily subordinated debt investments made prior to the financial crisis and recently the pandemic. With regard to the outlook, our new loans in our target market are attractive, and this vintage should be particularly appealing. Our experienced and talented team and our wide origination funnel are producing active deal flow. Our continued focus remains on capital preservation and being patient investors. We want to reiterate our goal to generate attractive risk-adjusted returns through income, coupled with long-term capital preservation. 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 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 June 30, net investment income was $0.35 per share and core net investment income was $0.22 per share. Core net investment income excludes $0.13 per share of one-time dividend income received from our equity investment in Dominion Voting, net of an increase in accrued excise taxes and incentive fees. Operating expenses for the quarter were as follows: interest and credit facility expenses were $10.1 million; base management and incentive fees were $8.9 million; general and administrative expenses were $1.9 million; and provision for excise taxes was $1.2 million. For the quarter ended June 30, net realized and unrealized changes on investments and debt, including provision for taxes, amounted to a loss of $2 million or $0.03 per share. As of June 30, our GAAP NAV was $7.72 per share, which is up 1.6% from $7.60 per share in the prior quarter. Our adjusted NAV per share was $7.67, which is up 3.1% from the prior quarter. As of June 30, our debt-to-equity ratio was 1.26x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. Our key portfolio statistics as of June 30 were as follows: our portfolio remains highly diversified with 129 companies across 27 different industries. The weighted average yield on debt investments was 12.7%. The portfolio was invested in 55% first lien secured debt, 9% in second lien secured debt, 10% in subordinated notes to PSLF, 4% in other subordinated debt, 5% in PSLF equity, and 17% in other preferred and common equity, with the portfolio being floating rate. Net to EBITDA on the portfolio is 4.8 times, and the LTM interest coverage is 2.4 times. The portfolio as a whole maintains a meaningful cushion regarding interest coverage; on a sensitivity basis for overall interest coverage to decrease to 1.0 times, base rates would need to go up 200 basis points, and EBITDA would need to decrease by 25%. This analysis is based upon the current run rate interest coverage, assuming a 5.5% base rate. 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 would like to open up the call to questions.

We'll take your first caller in the queue, that will come from Robert Dodd from Raymond James.

In your prepared remarks, there's been a lot of discussion about the ramp in the pipeline. Can you provide more insight into the factors driving this? Is it mainly a result of companies exiting the market? Has there been notable activity on the higher end or with refinancing add-ons? Any details on that would be helpful. Finally, how confident are you that these factors will actually come to fruition?

Thanks, Robert. The disclaimer, of course, is M&A can be lumpy, so lots of things that can go. Middle market M&A is a key driver of what drives deal flow. So a little bit, it's kind of like being an economist or predicting the weather. We are busy. We are busy. We are looking at a lot of deals. What's going to close on this side of September 30, and what's going to close on the other side of September 30 is hard to say. There's a lot of deal flow in the market. It's kind of though like a tale of two cities where you have some very high-quality companies that have very good growth characteristics. Those types of companies are still attracting very favorable multiples in terms of enterprise value as well as leverage. And that's one scenario. The other scenario is companies that do not quite have that robust growth profile or they may be viewed as a little bit more economically sensitive; those deals on the other hand are hard to predict. There's still, in some cases, significant gaps between buyers and sellers. They could come together. We’ve got pipeline activity in both of those categories, and we're fairly certain we're going to close a bunch of deals between now and year-end. But is it a very, very robust pipeline or a nice moderate pipeline? Who knows at this point. Our deal teams are working hard. We get a lot of inquiries. And it's nice to have capital around our platform to execute on that. The Joint Venture has a lot of capital availability, and we've been doing very well, and we're hopeful that we can continue to do well and ramp up that Joint Venture.

The second question is about portfolio companies that might be struggling a little bit more in this environment. How would you characterize the sponsors' reactions to that? Are they looking at stepping up and providing support, or at the margin, do you think that the decision-making is getting tougher for them? Any color from that side?

Yes. So in terms of sponsor reaction, I think it's thankfully as expected. In a situation like the pandemic, there was a lot of turmoil; that was a shock to the system. There, you might have seen sponsored behavior where people would just kind of write off and wash their hands of the bad deals and be willing to invest in the good deals. Thankfully in our scenario, they have basically invested in and supported the companies. This environment is less of a shock; it's more of a slow grind, with companies and sponsors absorbing what higher interest rates mean. So there’s less volatile movement of the cash flow, and because there's less volatile movement of their cash flow, they're not forced as much to make quick decisions about which companies they're going to support and which companies they're not. So these decisions are being made in a slower fashion, generally in a thoughtful manner. By and large, we've continued to see sponsors really support their companies with additional capital. Obviously, when they put in additional capital, it makes it easier for us and makes it easier for us to give them some concessions when they put some money in junior to us. Occasionally, it might not be careful, and those complications are more challenging, and we have to, obviously, be diligent and protect the interests of our investors, and be a little stricter regarding those situations. But nothing dramatic at this point. It's still kind of a slow-moving scenario, and we’re seeing sponsors put more money in.

We'll move to your next question, C.J. Alexander from Compass Point Research.

I just have one question, Art. Your deployments in the quarter, $70 million that you invested were in three new and 43 existing portfolio companies, which constitutes one-third of the portfolio. When you are looking at 43 companies at the same time, there must be something in common. What kind of trends are you seeing from those existing portfolio companies?

Yes. So good question, C.J. That's a combination, and this is where most of our activity happens. At least in a slower M&A environment, most of your activity is with your existing companies. Many of them have these delayed draws, DDTLs, where they're doing add-on acquisitions. So that’s a portion of it. And also, as you know, we have revolver commitments. The revolvers we do have, and we try to limit them, are usually priced at the same spread or, in some cases, a higher spread than the term loan. So delayed draws and revolvers have been key to the existing companies.

We'll hear next from Paul Johnson from KBW.

In the Joint Venture, how much capacity do you envision for growth there? I guess, can you grow it any more than it is today, or is it really at the level you'd like it to be in terms of percentage of your portfolio?

Yes. So today, the Joint Venture has about $800 million in total assets with the junior capital coming from us and Pantheon as well as the CLO. We can get to a little over $1 billion. It's a big contributor to our net investment income, so we really like it. It is in our 30% bucket, so it forms part of that. So kind of if it ain't broke, don't fix it. Speaking for PNNT, we'd like to continue to grow it, assuming we maintain our 30% bucket. I can't speak for Pantheon. These Joint Ventures have been very good for our BDCs. We have one in PFLT, as you know, with Kemper, and we have one in PNNT with Pantheon. These have been very good for the net investment income of the BDCs, and obviously, there's no additional management fee aside from, of course, the junior capital. So it's very efficient from the standpoint of our shareholders. We're going to look to continue to potentially grow them. The structures can be very robust. It's all kind of very secure, lower risk, first lien senior secured debt, which can be financed safely in several different ways, including securitization, CLO technology and long-term locked-in financing, generally at low cost, from which we create the attractive returns on capital. We'll continue to grow this Joint Venture and have continued discussions with Pantheon. We may even establish other Joint Ventures down the road.

Those have been, obviously, very successful for you guys. And then just kind of turning to the market. How do you observe the current situation? It seems like activity has been picking up over the summer. Are lenders holding the line in terms of discipline on terms, or is that starting to soften in any way?

As you know, the upper end of the direct lending market intersects with the broadly syndicated loan space, where we are not. The broadly syndicated loan space is starting to fall, and that will create deal flow which will create opportunities in the upper end, where the broadly syndicated loan market is competing with those folks. On the upper end of our market-—the $40 million to $50 million EBITDA companies— we're starting to see some of the upper market organizations move into that zone and apply pressure on that segment. So we still think the vintage for 2023 and 2024 is going to be a strong one, but we remain vigilant. We need to continue selecting solid credits and generating balance sheet capacity to take advantage of those credits. Nothing to report so far in our core middle-market segment, but we're watching closely.

We'll move next to Mark Hughes from Truist.

Any line of sight on repayments in the September quarter? How is that trending so far?

Nothing materially different, Mark, on repayments. We have them, and we're happy to receive repayments. When we underwrite loans, we are grateful when they pay us off, and it happens even in down markets. Even during the pandemic, certain companies paid us off, showcasing solid underwriting. But essentially, we're seeing a continuous flow of repayments. We're also observing new deals and, of course, the continued growth in the Joint Venture where we sell assets from PNNT to the Joint Venture. So it’s more of the same, but nothing meaningfully different.

When you think about the equity co-investments, does the turnover time change when you get into a challenging market or do terms and conditions tend to be stable for you, although they have been favorable for you in the last few quarters?

That's a nuanced question because we invest side-by-side with the sponsor. So there's not a significant difference in the investment we make with the sponsor. There's little negotiation over the terms. The question really is whether the multimile investment makes sense. Is it truly a company that's positioned for strong growth, or is it not? We've been pickier with equity co-investments over the last few quarters because the environment has made it more challenging to evaluate the economy. It might be one scenario to say, for instance, we feel secure making a loan with 4x cash flow, whereas the sponsor is paying 10x for the company, creating a six times gap beneath us as equity cushion. The second consideration, which is more traditional for us, involves whether or not we invest in the equity at 10x. Our cautious approach indicates that we have greater conviction to proceed. So essentially, we’ve simply been more selective regarding equity co-investments.

We'll hear next from Kyle Joseph from Jefferies.

Yes, I just want to gather your perspective on the economy and how it’s affecting your portfolio given its size and industry exposure. Can you provide insights on revenue and EBITDA growth trends, and whether companies at this point are starting to see any relief from inflation?

Yes, thanks, Kyle. Based on the numbers we're evaluating, it would support the soft landing scenario. Certain areas are sluggish, while others remain strong. However, when we review our platform, which encompasses over 170 companies across the economy, it suggests a solid landing. We're not observing significant areas of distress. Revenues are generally up across the platform, as are EBITDA figures. There are specific weaknesses, especially in the consumer sector. We've discussed Walker Edison, a furniture company that did well during COVID but has returned to the mean post-pandemic, and that has become a non-accrual. Nevertheless, overall, the data supports the soft landing theory. We model in a recession generally due to our underwriting practice. Even in a normal environment, we'd consider a recession happening at some point in our five-year loan period. Currently, we need to assume a recession occurs in year one given the existing economic climate, but we're comfortable with our loans even in recessionary environments. As for amendments being made, they're largely due to the significantly higher interest costs that companies are bearing now since base rates increased substantially. When first lien debts carry a rate of 12% or higher, coupled with considerable leverage, it impacts cash flow management, which invites situations where amendments are necessary.

You discussed your focus on smaller companies, but with all the headlines around banks and potential capital requirement increases, how will that shape your market? Do you see that as an opportunity for your business?

Yes, it should be. However, it’s still too early to ascertain the exact effects. Prior to the turmoil surrounding Silicon Valley Bank, we noted that many of the companies we were financing at 4 to 5x were getting cheaper refinancing from regional banks. Now that yields have dropped below 3x debt-to-EBITDA, regional banks, which would typically refinance those capital structures at much lower spreads, may be less present for companies we finance, such as ourselves or other direct lenders. It’s still premature to conclude how regional banks will impact that, but perhaps we can retain some of those credits for a longer duration, while some of our loans, which function at sub-3x, are yielding attractive returns. We're pleased with that situation.

We'll move next to Melissa Wedel from JPMorgan.

I wanted to touch on something you mentioned earlier in the call about the pipeline where it seems bifurcated, with higher quality companies commanding loftier valuations and more economically sensitive companies. When you consider portfolio management or construction for the BDC, do you have an optimal split in mind between those groups, or is it more about seeing what lands and determining if they're all suitable for the BDC?

That’s a great question. I think that tends to become clearer as time goes on. Obviously, we and perhaps others are more willing to apply leverage to higher quality, faster growing companies due to confidence in their growth trajectories and their ability to handle fluctuating economic conditions. Conversely, when our confidence ebbs regarding growth rates or economic resiliency, we typically decline opportunities altogether, which is our stance the vast majority of the time. Alternatively, we might structure a deal that’s economically sound, meaning lower leverage, sensible covenants that truly protect our investment, and having the substantial equity cushion. This cautious credit underwriting is typically done on a case-by-case basis. High-quality companies usually self-manage well, while there remains a whole segment of credit based on less robust quality companies that can still perform well; but you need to approach it with an awareness of your downside risks and maintain reasonable leverage with tight covenants. In the former instance, we might be more proactive regarding equity co-investment, while in the latter, we would likely choose to abstain. Generally, we’ve concentrated the majority of our portfolio in top-tier companies, which is our underwriting focus and where we operate.

My second question is regarding your dividend policy. You've mentioned increasing dividends for seven consecutive quarters. While there has been a lot of one-time income in this quarter and the previous quarter, as we consider a run rate for net investment income, and with expectations that rates may peak in the latter half of the year, should we be thinking about your dividend policy stabilizing for a while, rather than expecting continual increases?

It’s a great question, and every quarter it prompts discussions with our Board of Directors. Yes, it's difficult for me to guarantee seven more consecutive increases in the dividend—while I cannot commit to that, I shouldn’t and no one truly knows. It will largely depend on the quality of the portfolio and the prevailing base rates, as well as the earnings generated from the Joint Venture. We're transitioning to a monthly dividend starting in October, as we've found that there’s a segment of the investment community that appreciates such an approach. Thus, we'll evaluate it quarterly. We still believe that there's potential for growth within the Joint Venture, particularly with continued rotation of our equity holdings. While I've not detailed it much, there's still a significant portion—around 17% of the portfolio—invested in preferred and common equity that ideally will see rotation. So we feel optimistic about 2021, with substantial growth potential beyond that. But it’s challenging to provide an assertive statement at this point. I hope you can appreciate that.

And that does conclude the Q&A portion of our call today. I'd like to turn the conference back over to our host for any additional or closing comments.

Thanks, everybody. On behalf of Rick Allorto and myself, we want to thank everyone participating today. Our next quarter will be the 10-K, and we expect it to be better than mid-November. We look forward to seeing you all then. Wishing everyone a healthy and happy rest of the summer. Thank you.

That does conclude today's teleconference. We thank you all for your participation. You may now disconnect.