Pennantpark Investment Corp Q4 FY2025 Earnings Call

Good afternoon, and welcome to the PennantPark Investment Corporation's Fourth Fiscal Quarter 2025 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 Investment Corporation. Mr. Penn, you may begin your conference.

Good afternoon, everyone, and thank you for joining PennantPark Investment Corporation's Fourth Fiscal Quarter 2025 Earnings 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 and is the property of PennantPark Investment Corporation. Any unauthorized broadcast of this call in any form is strictly prohibited. An audio replay of the call will be available on our website. Additionally, I'd like to call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information. Our remarks today may include forward-looking statements and projections. Please refer to our most recent SEC filings 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. I'll begin today's call with an overview of our fourth-quarter results and discuss our ongoing strategy to rotate out of equity positions. I'll then share our perspective on the current market environment and how the portfolio is positioned for the quarters ahead. Rick will provide a detailed review of the financials, and then we'll open up the call for Q&A. For the quarter ended September 30, core net investment income was $0.15 per share compared to total distributions of $0.24 per share. We've previously communicated our plan to rotate out of equity positions and redeploy that capital into interest-bearing debt investments, which will drive an increase in our core net investment income. For many positions, our ability to drive exits is limited. However, we remain focused on this strategy and are comfortable maintaining our current dividend level in the near term as the company has a significant balance of spillover income, which we are required to distribute. PNNT has $48 million or $0.73 per share of undistributed spillover income, and we plan to use the spillover income to cover shortfalls in net investment income versus the dividend at this time. Regarding the current market environment for private middle-market lending, we are encouraged by a steady increase in transaction activity, which we expect will translate into higher loan origination volumes in the quarters ahead. Additionally, we continue to provide additional capital to many of our existing portfolio companies as they execute their respective growth initiatives, demonstrating the depth and resilience of our origination platform. We are optimistic that the increase in transaction activity will also result in opportunities to execute our equity rotation plan and rotate capital into new income-producing investments. We believe the current environment will favor lenders with strong private equity sponsor relationships and disciplined underwriting, areas where PNNT has a clear advantage. We continue to see opportunities to deploy capital into core middle-market companies where leverage is lower and spreads are higher than in the upper middle market. In the core middle market, the pricing on high-quality first lien loans is SOFR plus 4.75% to 5.25%. Leverage is reasonable, and we continue to get meaningful covenant protections while the upper middle market is primarily characterized as covenant light. Turning to our portfolio performance. As of September 30, the median leverage ratio on our debt security was 4.5x and the median interest coverage ratio was 2x. For new platform investments made during the quarter, the median debt-to-EBITDA was 4.3x, interest coverage was 2.5x and the loan-to-value was 39%. Credit quality of the portfolio continues to perform well. We have 4 non-accrual investments, which represent 1.3% of the portfolio at cost and 0.1% at market value. Two new investments were added and 2 prior investments were removed from the non-accrual list. These strong credit metrics reflect the rigor of our underwriting process and the discipline of our investment approach. We continue to believe that our focus on the core middle market provides us with attractive investment opportunities where we provide important strategic capital to our borrowers. The PennantPark platform has a demonstrated track record of value creation through successful financing of growing middle-market companies in 5 key sectors, enabling us to ask the right questions and consistently deliver strong investment outcomes. 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 and have a limited direct impact from the recent tariff increases and uncertainty. Companies in the core middle market, with $10 million to $50 million of EBITDA, are below the threshold and do not compete with the broadly syndicated loan market 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 are attractive. We have many weeks to do our diligence with care. We thoughtfully structured transactions with sensible credit statistics, meaningful covenants, and substantial equity cushions to protect our capital, attractive spreads, and equity co-investment. Additionally, from a monitoring perspective, we received monthly financial statements to help us stay on top of the companies. Our rigorous underwriting standards remain central to our investment philosophy. Nearly all of our originated first lien loans include meaningful covenant protections, which is a key differentiator versus the upper middle market where covenant-light structures are more common. Since our inception nearly 18 years ago, PNNT has invested $9.1 billion at an average yield of 11.2%, while maintaining a loss ratio on invested capital of roughly 20 basis points annually, a testament to our consistent and disciplined approach through multiple market cycles. As a provider of strategic capital, it fuels the growth of our portfolio companies. In many cases, we participate in the upside of the company by making equity co-investments. Our returns on these equity co-investments have been excellent over time. Overall for our platform, from inception through September 30, we've invested over $596 million in equity co-investments and have generated an IRR of 25% and a multiple on invested capital of 2x. As of September 30, our portfolio totaled $1.3 billion. And during the quarter, we continued to originate attractive investment opportunities and invested $186 million in 9 new and 54 existing portfolio companies. Our PSLF joint venture portfolio continues to be a significant contributor to our core NII. As of September 30, the JV portfolio totaled $1.3 billion. And over the last 12 months, PNNT's average NII yield on invested capital in the JV was 17%. The JV has the capacity to increase its portfolio to $1.6 billion, and we expect that with this additional growth, the JV investment will enhance PNNT's earnings momentum in future quarters. From an outlook perspective, our experienced and talented team and our wide origination funnel is producing active deal flow. We remain steadfast in our commitment to capital preservation and disciplined, patient capital investment approach. We reiterate our objectives to deliver compelling risk-adjusted returns through stable income generation and 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 investments, and we pay out those contractual cash flows in the form of dividends to our shareholders. With that overview, I'll turn the call over to Rick for a more detailed review of our financial results.

Thank you, Art. For the quarter ended September 30, GAAP net investment income and core net investment income were both $0.15 per share. Operating expenses for the quarter were as follows: interest and credit facility expenses were $10 million, base management and incentive fees were $6.1 million. General and administrative expenses were $0.9 million and the provision for excise taxes was $0.7 million. For the quarter ended September 30, the net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $10.8 million. As of September 30, our NAV was $7.11 per share, which is down 3.4% from $7.36 per share in the prior quarter. As of September 30, our debt-to-equity ratio was 1.6x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. The PSLF JV is evaluating the purchase of $120 million to $140 million of assets from PNNT, which would allow PNNT to reduce its leverage ratio to 1.25 to 1.3x, which is in line with its target ratio. As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 166 companies across 37 different industries. The weighted average yield on our debt investments was 11%. We had 4 non-accruals, which represent 1.3% of the portfolio at cost and 0.1% at market value. The portfolio is comprised of 50% first lien secured debt, 2% second lien secured debt, 12% subordinated notes to PSLF, 5% other subordinated debt, 6% equity in PSLF, and 25% in other preferred and common equity investments. Ninety-one percent of the portfolio is floating rate, debt-to-EBITDA on the portfolio is 4.5x, and interest coverage is 2x. Now let me turn the call back to Art.

Thanks, Rick. In conclusion, we remain committed to delivering consistent performance, preserving capital, and creating long-term value for all stakeholders. Thank you to our team for their dedication and our shareholders for their continued partnership and confidence in PennantPark. That concludes our remarks. At this time, I would like to open up the call to questions.

We'll take our first question from Brian Mckenna with Citizens.

So on the dividend, I appreciate the equity rotation opportunity. I know that's something you guys have talked about the last few quarters here. But if you were to rotate $150 million of assets into income-producing loans at an incremental 10% yield today, that equates to about $0.20 per share of NII over the next year. So at the current quarterly run rate of $0.15, that implies about $0.80 of annual NII before any changes in base rates and credit quality, that's still $0.15 below the current dividend. So why not right-size the dividend today so some of this incremental earnings from the equity rotation accretes NAV?

Yes. We're continually assessing the dividend. We have a significant amount of spillover that needs to be distributed. The key consideration is how and when to make those payouts while simultaneously managing the equity rotation to determine the long-term sustainable net interest income. We're addressing both the equity rotation and the distribution of spillover. Our current strategy is to navigate both of these processes over the next few quarters, evaluate our position, and then make informed decisions.

Okay. That's helpful. And just in terms of timing around any realization events in some of these equity positions, has anything changed in the last quarter or 2? It sounds like a more constructive backdrop should be better for monetizing some of those. But I'm just curious if there's any update relative to expectations over the last quarter or 2.

Yes. No, we're seeing more activity. As we said, we're hopeful that we're getting closer to some rotation opportunity. Nothing to announce here on this call today, but we're feeling and sensing that the M&A opportunity and the opportunity for some of these companies is closer at hand than it was.

We'll take our next question from Robert Dodd with Raymond James.

Regarding equity rotation, take Flock as an example; it has surpassed its original cost following a restructuring. Despite some challenges, it is performing very well. Do you believe that businesses like this are more likely to transact and provide a realization for you, which is somewhat beyond your control, or do you think other types of businesses, perhaps those still facing difficulties, are more likely to change hands in the near term? What are your thoughts?

Yes, there are some areas where we have more control, such as Flock, which deals with consumers who have credit issues and troubled receivables. Given the current economic situation affecting consumers, we believe Flock is well-positioned. I don’t want to stray from the main question, but we do have control in certain areas. Flock is one example, along with JF Acquisitions and AKW. The key consideration here is timing and how we can best optimize our exit strategy. Additionally, we have various equity co-investments where we lack control. However, if there is a favorable M&A environment, some of these co-investments may eventually convert to cash. In summary, our situation involves both scenarios. We have a bit more control over certain investments, and it's really about how we can maximize the results.

Got it. Regarding the potential transactions and the sale of certain assets, you're reviewing this, correct? What obstacles need to be addressed for you to feel assured about moving forward? Additionally, do you believe the SEC would approve this? I’ve noticed that some BDCs have attempted similar actions in the past, and the SEC has rejected them.

Yes, I think there may have been a misunderstanding. We are looking into the possibility of selling assets to the joint venture. What we mentioned is that transitioning assets from BDC, PNNT to the PSLF joint venture is a normal process. At the end of the quarter, the leverage at PNNT was slightly high at 1.6 times. We prefer to wait until the end of the quarter to obtain the most current third-party valuation for these assets. Currently, PSLF is considering the purchase of $120 million to $140 million of those assets, which will be transferred from PNNT to PSLF, helping to realign the PNNT leverage ratio with our target of 1.25 to 1.3 times debt to equity at PNNT.

I see. Yes, I misunderstood that. Regarding your leverage, it's currently a bit high. This initiative is one way to reduce it, along with others. However, there's also the spillover that needs to be managed. Maintaining the dividend at its current level will help address this gradually. Alternatively, a one-off solution could resolve it quickly, but any approach that excessively distributes earnings tends to increase leverage. How confident are you that with the current dividend strategy and other initiatives, you can achieve the target leverage and maintain it?

Yes. Look, it's really a question of how we work down our spillover and when we work it down at the same time as we're working on equity rotation. Our target leverage long term for PNNT is that 1.25 to 1.3x. We will temporarily consider going above it if we're confident that PSLF will want some more assets and we can grow PSLF, which has been highly accretive to PNNT. So you've got multiple things going on. You've got the reduction of the spillover over time. You've got the equity rotation, and you've got the leverage ratio at PNNT. So those are the constraints. We're doing our best. Some of the stuff we control, some of it we can't. We're always evaluating dividend policy. That said, we still have substantial spillover that we need to pay out, and we also need to keep our leverage reasonable and comfortable. So if you have suggestions, Robert, we're all ears, but these are the constraints we're working with.

We'll take our next question from Melissa Wedel with JPMorgan.

I wanted to start on the NII this quarter. I'm wondering if there was anything maybe skewed in terms of timing during the quarter that may have been a headwind. For example, maybe paydowns came early and fundings came later. Was there anything like that we should be thinking about?

I mean not off the top of my head. Rick, any thoughts from you?

No, same, nothing jumps out in terms of timing of repayments.

Okay. Okay. And then a follow-up question on how you're thinking about the spillover income. I mean you've made it clear that you look at that as a way to supplement any shortfall versus the dividend. In terms of sort of banking any spillover income, do you look at that full $0.73 per share as something that could be used? Or are you looking to retain some level of spillover income?

Yes. Look, there's certainly a level of spillover income that we certainly would consider and should consider retaining. For instance, if you look at PFLT, the sister BDC, I think there's like $0.25 or $0.30 of ongoing spillover, that kind of thing. So that might be a base level once you get down to that where you're comfortable that you're not required to pay it out, something like that.

We'll go next to Arren Cyganovich with Truist Securities.

With the investment activity picking up, can you provide a little color around what types of deals you're seeing? Are they more M&A focused? Are these kind of follow-on acquisitions? And maybe just if there's any particular industries that you're seeing more activity in?

Thanks, Arren. It's a combination. A lot of it is add-on delayed draw term loans where we're already in existing credit and the credit needs growth capital. It's a big part of what we do is start with that company when it might be $10 million or $20 million of EBITDA, and they have plans to get to $30 million, $40 million, $50 million, and we set up a plan with them to provide the debt capital to fuel the growth. So quite a bit of it, I'd say at least half of the activity is with existing incumbent companies. The good news about that is we're on top of companies. We're not going to fund them unless they're doing very well. So by definition, the credit quality is very strong. We know exactly what we're getting into, and we're financing additional capital into companies that are performing well. And then about the other half is kind of our typical new deal, new platform, mid-4s leverage, over 2x interest coverage, 40%, 50% loan-to-value, SOFR plus 4.75% to 5.25% in this environment type of loan.

We'll go next to Christopher Nolan with Ladenburg Thalmann.

For the companies that you're funding, given that the EBITDA coverage is going down, the interest coverage is going up, is this a recipe for dividend recaps by the private equity sponsors? Or do your covenants prevent that?

Well, certainly, it's a great question. We had a dividend recap in PFLT, we talked about, which was a nice realized gain where we were in the equity and the debt, but we have a substantial equity position. So dividend recaps for us as a lender are something that have a high bar. As a new lender, we are always cautious around use of proceeds and having alignment of interest and making sure there's substantial equity beneath us. That said, when companies do well, they look at their options, dividend recaps being one of them, sales, IPOs. So the dividend recaps have helped us where we have had the equity co-invest. We are very cautious about participating in them as a lender. So sometimes it just happens. Someone comes and takes us out to give an aggressive loan to a borrower, we get financed out of our debt and our equity gets some sort of dividend. So you're seeing a bit more of that in this market more recently, and we certainly experienced that in our other BDC.

And Art, how would you characterize the trends in the private equity space that you operate in because the hold times for the private equity in general has been quite extended. And are we starting to see a break in that log jam at all?

Yes. When we discuss equity rotation, many of our equity co-investments are experiencing that. We co-invested with a private equity sponsor, and as we approached 2025, things were looking positive. However, after Liberation Day on April 1, the M&A market significantly slowed down for about three to four months. It's beginning to recover now, which is why we feel a bit more optimistic today compared to last quarter about nearing some meaningful equity rotation. We hope the markets will support this. This situation stems from buyers and sellers finally finding common ground, especially now that there's been some market stability. Sellers were previously holding out for higher prices while buyers sought lower ones. Additionally, if interest rates and borrowing costs decrease, this could further catalyze M&A activity and refinancings. The market has been uncertain since Liberation Day, but it seems to be improving. We will see how the Fed acts in early December, but without any major market disruptions, we are more hopeful about achieving some reasonable rotation.

Got it. And one for Rick. Rick, just to rephrase, I think, Melissa's question earlier, given that revenues seem to go down while investment assets went up and there's a small decline in average yield. Were there timing issues involved in terms of closing deals late in the quarter?

None that comes to top of mind. I think the biggest variance kind of quarter-over-quarter on the top line is you're going to see is in the PSLF dividend. That dividend did decrease in the current quarter. There were some expenses at the joint venture that were kind of one-time and reduced the dividend.

I'd say, that's a good point. There's been some financing activity at the joint venture in the securitization side that kind of hit expenses to some extent during the quarter.

We'll go next to Brian Mckenna with Citizens.

Art, just a bigger picture question for you. You've obviously been a leader in the space for some time now, and you've done a pretty good job managing PennantPark through a number of operating and macro environments, including the GFC, COVID, et cetera. There's clearly a lot of noise in the market today around private credit. And at least from my perspective, there continues to be a good amount of misinformation. So it would be great just to get your thoughts on all the current events and what you think is still underappreciated or misunderstood about your business and even the industry more broadly.

Yes, that's a great question, and we often receive inquiries from investors who are new to this space. When people hear the term default, they sometimes interpret it as a total loss. However, in the lending industry, default simply means that we enter negotiations to establish an appropriate capital structure for the future of the company. This could involve converting some debt into equity, offering more benefits to lenders, or both. In some cases, converting debt to equity can generate long-term value. Over our 18-19 years in business, we have seen instances where these equity conversions create significant value. In fact, converting debt to equity can sometimes be more profitable. It’s essential to grasp how loans operate and what it means to be a lender; when we say we are lending at a 40% or 50% loan-to-value ratio, it indicates that 50% to 60% of the company's value would need to decline before we incur a loss. While that situation can occur, there's considerable cushion built into these transactions due to the substantial equity cushion available. For instance, during the onset of COVID, we had around 120 companies to which we provided loans. With the government shutting down the economy, it was critical for us to conduct quarterly maintenance tests, requiring companies to meet specific debt-to-EBITDA and interest coverage ratios. Consequently, we engaged in constructive discussions with our borrowers. Out of those 120 companies, only about 15 required additional liquidity. In each of those cases, the private equity sponsors stepped in to address the liquidity issues, even in the challenging economic circumstances at that time. Looking back to the Global Financial Crisis, we noticed that when public fear escalated and negative articles circulated, we mitigated those concerns by reviewing our portfolio line by line. For BDCs, the statements of investments are publicly available. By thoroughly discussing each company—who they are, what they do, the industry they're in, as well as credit statistics and ratios—we can provide clarity. Analyzing the overall portfolio shows that we maintain a debt-to-EBITDA ratio of 4.5x, a loan-to-value ratio between 40% and 50%, and interest coverage exceeding 2x. If investors examined these details carefully, they would recognize the robustness of the loan books, including ours and those of our peers. Plus, we consistently monitor these portfolios. Every month, we receive financial statements from the companies in our core middle market. This means we can quickly address any issues that may arise, and every quarter, there are financial covenants that they must adhere to. The quality of these portfolios remains high, and we maintain a close watch over them. If investors could allocate time to review the details and we, along with our peers, were available to guide them through it, many of the current concerns could be alleviated. I hope this information is helpful.

At this time, there are no further questions. I will now turn the call back to Art for any additional or closing remarks.

Look, I just really want to thank everybody for participating today in this season of Thanksgiving. We are certainly grateful for the support of our shareholders. We wish everyone a safe and happy Thanksgiving and holiday season, and we look forward to speaking to you in early February.

This does conclude today's conference. We thank you for your participation.