Pennantpark Investment Corp Q1 FY2024 Earnings Call

Welcome to PennantPark Investment Corporation's First Quarter 2024 Earnings Conference Call. Today's conference is being recorded. All participants are in a listen-only mode at this time. There will be a question-and-answer session after the speaker's remarks. 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 first fiscal quarter 2024 earnings conference call. I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

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 filing with the SEC for important factors that could cause actual results to materially differ 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.

Thank you, Rick. We're going to spend a few minutes and comment on the current market environment for private credit, provide a summary of how we fared in the quarter ended December 31; how the portfolio is positioned for upcoming quarters; a detailed review of the financials; and then open it up for Q&A. For the quarter ended December 31, our GAAP and core net investment income was $0.24 per share. GAAP and adjusted NAV decreased 0.6% to $7.65 per share from $7.70 per share. As of December 31, our portfolio grew to $1.2 billion or 16% from the prior quarter. During the quarter we continued to originate attractive investment opportunities and invested $231 million in 12 new and 32 existing portfolio companies at a weighted average yield of 11.9%. For the investments in new portfolio companies, the weighted average debt to EBITDA was 3.7 times. The weighted average interest coverage was 2.4 times and the weighted average loan-to-value was 55%. Credit quality of the portfolio is stable. We had no new non-accruals in the quarter ended December 31. As of December 31, the portfolio's weighted average leverage ratio through our debt security was 4.9 times. And despite the increase in base rates through 2023, the portfolio's weighted average interest coverage ratio was 2.2 times. On average, we have seen a 25 basis point tightening of first lien spreads. However, we continue to believe that the current vintage of core middle market directly originated loans is excellent. Leverage is lower, spreads and upfront OID are higher and covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market, in the core middle market, we are still getting meaningful covenant protections. At December 31, the JV portfolio equaled $858 million, and during the quarter, the JV invested $81 million including $8 million of purchases from PNNT. Over the last 12 months, PNNT earned a 19% return on invested capital into the JV. We expect that with continued growth in the JV portfolio, the JV investment will continue to enhance PNNT's earnings momentum in future quarters. Now let me turn to the current market environment. In an uncertain market environment, we are well-positioned as a lender focused on capital preservation in 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 for our borrowers. We have a long-term track record of generating value by successfully financing growing middle market companies in five key sectors. These are sectors where we have substantial domain expertise and know the right questions to ask. They are business services, consumer, government services and defense, health care, and software and technology. These sectors have also been recession-resilient and tend to generate strong free cash flow. The core middle market, which are companies with $10 million to $50 million of EBITDA, is below the threshold and does not compete with the broadly syndicated loan or high-yield markets unlike our peers in the upper middle market. In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, upfront OID, and equity co-investment. Additionally, from a monitoring perspective, we receive 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 is a perception 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 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. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall for our platform from inception through December 31st, we've invested over $448 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1 times. Since inception nearly 17 years ago, PNNT has invested $7.8 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of approximately 18 basis points annually. This strong track record includes investments primarily in subordinated debt made prior to the global financial crisis, legacy energy investments, and recently the pandemic. With regard to the outlook, new loans in our target markets are attractive, our experienced and talented team and our wide origination funnel is producing active deal flow, and 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 preservation of capital. 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 December 31, GAAP and core net investment income was $0.24 per share. Operating expenses for the quarter were as follows: interest and credit facility expenses were $9.6 million, base management and incentive fees were $7.3 million, general and administrative expenses were $1.4 million, and provision for excise taxes were $0.4 million. For the quarter ended December 31, net realized and unrealized changes on investments and debt, including provision for taxes, was a loss of $5 million or $0.08 per share. As of December 31, our GAAP and adjusted NAV was $7.65 per share which is down 0.6% from $7.70 per share in the prior quarter. As of December 31, our debt-to-equity ratio was 1.4 times, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of December 31, our key portfolio statistics were as follows: our portfolio remains highly diversified with 139 companies across 30 different industries, the weighted average yield on our debt investments was 12.6%, PIK income equaled only 3% of total investment income. We had one non-accrual, which represents 1% of the portfolio at cost and 0% at market value. The portfolio is comprised of 58% first lien secured debt, 7% second lien secured debt, 9% subordinated notes to PSLF, 4% other subordinated debt, 5% equity in PSLF, and 16% in other preferred and common equity. 96% of the debt portfolio is at floating rate. The debt to EBITDA on the portfolio is 4.8 times, and interest coverage is 2.2 times. 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.

Thank you. Our first question comes from Mark Hughes of Truist.

I'll go with the Mark Hughes part of that. Good afternoon. Rick, what did you say the EBITDA coverage was on the overall portfolio?

So EBITDA was 4.8 times and the interest coverage was 2.2 times.

Yes. Thank you. And then any nuance now about the attractiveness of either subordinated debt or the preferred or common. The first lien has obviously been attractive. But anything about the dynamic where you might see a little bit more of a preference for some of those other categories?

Yes. Thanks, Mark. And by the way just to clarify Mark Hughes is with Truist. And look we do invest across the capital structure. Obviously, it's been really good to do first lien in this higher yield environment with the vintage and the good credit stats as well as classically will do equity co-invest to participate in some of the upside. There are interesting second lien, sub-debt and pref deals to look at. They just haven't been that interesting relative to first lien recently. But we will continue to look. And if we have real conviction, we'll potentially consider adding some of that to the portfolio judiciously and carefully.

Thank you.

Next we go to the line of Robert Dodd with Raymond James. Please go ahead.

Hi, guys. And congratulations on the quarter. Just on the activity in the quarter, I didn't catch this if you said in the prepared remarks. Can you give us an idea how much of that origination was really late in the quarter? Because it certainly looks like you originated a lot interest income moved that much late, right? So I presume a considerable portion of that was very late. But like just how much?

Yes. Thank you, Robert. So about 40% of the origination was done in the month of December.

Thank you. As you mentioned, some of my questions have already been addressed in a previous call. Regarding the key sectors you focus on, such as business and government, has there been any change in their relative attractiveness? Looking at the initial pipeline for the remainder of the year, is it primarily concentrated in those sectors, aligning with your preferences? How does that look in terms of potential opportunities?

So, in general, look, we've been very active in defense and government services. We're one of the leading lenders in that space given what's going on geopolitically, we feel like there's really nice tailwinds to that space. So we've been very active there. And for us, we've had a really good track record, very stable, steady, and now potentially growing. Health care continues to be active for us. Now some of our peers have stumbled a little bit in health care. We've thankfully avoided some mistakes, and our way of looking at it and avoiding reimbursement risk, keeping leverage low, trying to get behind companies that are helping bring high-quality care at low cost has generally performed well from a credit standpoint. And then business services, which is a big catch-all. Business services can mean a lot of things. We're active there. We've been less active in tech/software. It's always been one of our smaller verticals. We lend against cash flow. We don't lend against revenue and we lend reasonable levels of cash flow. So, it's a sector for us. It's not one of our bigger sectors. And then consumer remains a sector for us. We've been a little bit more cautious there given some of the potential volatility around the consumer. We've done better there when we've had brands that have some meaning. And we haven't done a lot there recently, but if you look at kind of what's worked for us and what hasn't worked, branded had meaning has worked. So, it's really been government services, defense, health care, and business services is kind of the big three for us.

Perfect. You mentioned that business services and health care are low priority areas. Additionally, you noted that there hasn't been significant development in site positioning or roll-ups, which raises concerns about reimbursement risks. Is there interest in the overlap between health care and government? You've seen some successes in that field. What are the current promising areas within that sector?

Yes, there are many different niches within this vast industry, which constitutes about 20% of the GDP of the United States. There are various niches of care, services, and synergies among small or medium-sized providers. It's important to bring them together and manage relationships with payers who seek efficiencies in their payments. There are a wide variety of ways to identify potentially stable or growing healthcare niches that generate high free cash flow while offering care at costs that payers consider reasonable. This sector is enormous, and we can discuss specific names from the portfolio in more detail later. All the information is available in the Statement of Investments, and individuals can visit the Pennant website to learn more about our activities.

Got it. Got it. One last one if I can on credit. Obviously, interest coverage et cetera that looks good. Obviously, there's always going to be some marginal companies in the portfolio, but that's always the case anyway. I mean in terms of trends? Are you seeing any emerging signs of weakness maybe not even in the portfolio but across businesses that are coming to market now? I mean it just seems everything is hanging in on a credit front-wise broadly much better than I would have thought if it's me certainly like two years ago. So, is anything catching up to anybody yet? Or is it just everything picks along and everything is doing relatively fine?

Yes, we agree. As lenders, we tend to be skeptical by nature, which leads us to underwrite with the assumption of a recession. Looking back at our discussions from a year or two ago, we made it clear that we were underwriting with this recession assumption, even though it hasn’t materialized. Our credits are generally performing well because of this approach. However, we did not foresee base rates being at their current levels, which has been somewhat surprising. Overall, it has been beneficial for us as the yields we're obtaining are excellent. If these base rates remain high for an extended period, we might see some companies in a portfolio of 100 or 150 needing amendments or adjustments, as it becomes too expensive for them. When the Fed eventually begins to ease, this could provide some relief to those companies. Nonetheless, it's a given that in any sizable portfolio, some companies will require support over time. Despite our confidence in our performance and that of our peers, along with the overall growth in EBITDAs of 5% to 10%, there will always be a few companies needing assistance.

Got it. Thank you.

Next, we go to the line of Casey Alexander with Compass Point. Please go ahead.

Hi. Good afternoon. Thanks for taking my questions. And pretty simple stuff here. This one is just first maintenance. The weighted average yield dropped, if I'm correct about 40 bps quarter-over-quarter, which is actually a fair amount in this environment. Is that new weighted average impacted by the fact that you're now carrying the government securities in the portfolio as opposed to categorizing them as cash and cash equivalents?

Well, I'll take the first crack and kick it over to Rick. I mean for sure we've seen as we said spread compression. So the new deals there are coming in, call it 25 bps tighter from a spread compression standpoint, since we have been very active, the weighted average certainly has come down. Rick, I don't know if you have any other commentary other than that.

I'll just confirm that the government securities are not included in the calculation of the weighted average yield. So they are not impacting the outcome.

Okay. I noticed in the SOI that you made a new loan of $50 million to Mid-Ocean. I think you have been involved with that company for a while. Could you explain your history with Mid-Ocean and what made you decide to invest an additional $50 million this quarter?

It's a great question and you're very astute at highlighting this. This is a company called JF Petroleum, which we've had for a while. It was originally a mezzanine deal, then it was a restructured deal, where we owned a chunk of equity and was restructured once again where we basically just became an equity holder. The company has seen a resurgence. There have been some very smart add-on acquisitions that have been made. The company has come back very, very strongly and you could track the value of the equity; there's an equity piece that's been marked up. It's coming back strong. And the company, we'll see, I've learned not to overpromise Casey, and you can appreciate that. The company is coming back strong. I just put it at that and we'll see where we go.

All right. Thank you for taking my questions.

Next we go to the line of Paul Johnson with KBW. Please go ahead.

Good morning. Thanks for taking my question. I was just hoping to get a little bit more color maybe on just what drove the depreciation this quarter. Was it just broad across the book? Or were there any loans in particular that were mainly driven down?

Yeah. So picking up to Casey's last point, JF was up substantially. The three loans that have been marked down are Flock Financial, Walker Edison, which was a restructuring, which remains challenged, and a company called Atlas Purchaser. So those were the three biggest declines in loans that got marked down during the quarter.

I noticed that Flock Financial was a larger loan in your portfolio that was marked down this quarter. Could you explain what that business is and what caused the weaker mark this quarter?

Yeah. It's a specialty finance company. They are focused on busted credit card receivables, auto receivables. And they've had some recent stumbles. We are in there working with them to help solve the problem. It could be a really good sector. They've made some mistakes. And we're in there working with the company in trying to help them grow, solve their problem, and build back up.

Got it. I appreciate the color there. Two more. Just on the equity co-investment, it sounds like there could be some possible rotation there this year, which would be great. I was wondering if it's at all possible to quantify that in any way maybe without names or if there's even just any particular industry that maybe you would expect that it's ripe for deals just any clues there would be helpful.

In the quarter ending in December, we saw the sale of a company called TBC, in which we had some equity. So far this year, we have had another exit with a recent sale, the name of which will be public when we discuss it in May. We are beginning to see some positive developments in mergers and acquisitions, along with the challenges that come with them, including repayments from some of our stronger investments. This can be seen as both good and bad news. As we mentioned, equity co-investment is often part of the arrangement in many of these deals, and we will receive some liquidity from these equity investments, though they are not significant on their own. However, smaller amounts can accumulate over time and prove useful. Historically, our multiple on invested capital has been greater than two times, and both TBC and the company I mentioned were in the three to four times range. We cannot predict these outcomes with certainty, but as deal flow increases, we hope to see further equity rotation.

Got it. Thanks for that, Art. And last one, I'm just wondering if you guys have any sort of idea within the portfolio? I mean if you've seen trends of higher PIK utilization from your sponsors or even if you have any idea if that's the case if you're seeing higher PIK utilization, what sort of percent of your loans might be on PIK at the moment? I would just assume obviously with base rates where they're at expected to stay high for – even for – into the rest of the year that could be something we would see. But just curious to get your thoughts on that.

Rick, do you want to talk about PIK income?

Yes. Paul, for the quarter, PIK income was about 3% of total income. So currently it's at a relatively low percentage.

Outlook – from an outlook standpoint, Paul, look, as we said if this higher for a longer trend continues inevitably, some companies are going to need some relief. And part of amendment structures could be PIK. So 3% feels really good now and we're very proud of that. But we'll just see how long is the higher for longer trend continues and quite possibly it could go higher than 3%.

Thanks. That’s all for me. Appreciate the answer today.

Thank you.

We go next to Brian McKenna with Citizens JMP. Please go ahead.

Okay. Great. Most of my questions have been asked but I just had one question for you. So we've seen some consolidation in the public BDC universe. And I think really what some of these consolidation announcements are getting at are greater scale and bigger kind of public vehicles. So would you ever look to merge PNNT with PFLT just to kind of create a bigger publicly traded vehicle? And if that's something you would look at? I mean what would kind of have to take place or align for that to take place?

Yes. Thank you. So look we – all things are always on the table. So let me just state that. We're always looking for ways to enhance shareholder value. Over time PNNT has had a different investment orientation, a little bit lower in the capital stack a little bit higher return. In addition, PNNT as we know has had a chunkier, lumpier performance and NAV. So – and it's not traded as well quite frankly as PFLT, PFLT has had, what we think is a fairly pristine track record. So it's something we look at from time to time. We are always looking to say "Hey, does it make sense to have two different strategies." Does it make sense to have two different strategies? As PNNT hopefully gets less lumpy and hopefully trades better then that discussion might be something kind of more current. But it's something we look at, something we evaluate and it's a good question.

Helpful. Thank you.

We go next to Melissa Wedel with JPMorgan. Please go ahead.

Good afternoon. Thank you for taking my questions. Most of my questions have already been addressed, but I wanted to discuss portfolio leverage. Following a very productive December quarter in terms of originations, it appears that portfolio leverage has increased above your target level. Are you comfortable with the current levels, or are you considering adjusting your holdings in government securities to move closer to your target?

Yeah. So, there's a couple of different things in your question. First, the JV, kind of the way the JV works is we usually season assets at the BDC level at PNNT. And then after they season, they may move on to the JV. So December 31 was a moment in time. It was a moment in time. So our goal is really to kind of get down to kind of our core target, which is around the zone of 1.25 times. So 1.4 times, we're a little higher than that. So we're going to look to get back down to our target as assets move from the BDC level to the JV over time. Rick, do you want to cover the treasuries, the government securities and what we do, and how we do it, just to clarify?

Sure. So at quarter end, we are executing and putting on balance sheet some US treasuries, just from a perspective of kind of balance sheet optimization in terms of kind of how we think about utilizing kind of that 30% asset bucket.

We don't label the underperforming asset category negatively; instead, we refer to it as a positive asset category, specifically the 30% opportunistic category. To clarify, our joint venture has been quite successful and beneficial for PNNT shareholders. We appreciate this aspect as part of our 30% category and are open to further expanding the joint venture. This approach allows us to maintain flexibility and optimize that 30% category.

Okay, that's helpful. I appreciate it. I have a separate question. It seems that there was significant activity with both new and existing companies in the December quarter. I'm curious about what you're observing regarding existing companies and how they are using the proceeds from additional borrowings. Are there any trends or noteworthy points?

Yeah. Look, a lot of what we do is start off with companies as a platform in a particular sector where the private equity sponsor says, hey, this is our platform company. We're going to go execute a strategy of doing add-on acquisitions. And we finance them either with delayed draws or just add-ons and incrementals. And it's part of our normal flow. Again, this is where our equity co-invest can be helpful where we're helping them grow the platform, and we can participate in the upside. So, nothing really dramatic. It just we were active in that calendar Q4, and that activity included existing portfolio companies.

Okay. So that was companies drawing down on existing facilities or you're seeing some incremental add-on acquisition?

Well, in most cases, there's a delayed draw term loan that's structured at the beginning of a deal. And that delay draw is meant to be relatively easy for the borrower to access to do add-on acquisitions or grow subject to certain thresholds. So, much of that is delay draw term loan facilities being drawn. Occasionally, it's an incremental that's not as delayed draw but much of it is a delay draw that's being drawn.

Got it. Thanks, Art.

And we have no further questions. I'd like to turn the floor back to Mr. Art Penn for any additional or closing remarks.

Thanks everybody for being on the call today. We look forward to speaking to you next in May. Have a great day.

This concludes today's conference. We thank you for your participation. You may disconnect your lines at this time.