Earnings Call Transcript - PNNT Q2 2022

Operator, Operator

Good afternoon, and welcome to the PennantPark Investment Corporation's Second 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 a question-and-answer session following the speakers’ 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.

Art Penn, Chairman and CEO

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's second fiscal quarter 2022 earnings conference call. I'm pleased and I am joined today by Richard Cheung, our Chief Financial Officer. Richard, please start off by disclosing some general conference call information and include a discussion of our forward-looking statements.

Richard Cheung, CFO

Thank you, Art. I'd like to remind everyone that today's call is being recorded. Please note that this call is the property of PennantPark Investment Corporation, and any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release as well as 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.

Art Penn, Chairman and CEO

Thanks, Richard. I'm going to spend a few minutes discussing how we performed in the quarter ending March 31st, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, then open up for Q&A. From an overall perspective in this era of inflation, rising interest rates, and geopolitical risk, we believe we are well positioned as a lender focused on the United States where the floating rates on our loans can protect against rising rates and inflation. We are pleased to be lending into the core middle market where we are important strategic capital to our borrowers. We believe we are additionally well positioned as a company that has a clear game plan for growth of net investment income and dividends. The highlight of the quarter ending March 31st was the sale of Pivot Physical Therapy, which generated cash proceeds of $232 million, our second lien position, which had a cost of $49 million exceeded cash proceeds of $78 million resulting in an IRR of 14.3% and a multiple on invested capital of 1.6x. Our common and preferred stock investment, which had a cost of $35 million was exited for $164 million resulting in a 40% IRR and a multiple on invested capital of 3.3x. Due primarily to this successful exit of Pivot, we have made progress on our three-part plan to increase long-term shareholder value. Number one, last quarter we increased our quarterly dividend to $0.14 per share, up from $0.12. We're announcing another increase this quarter to $0.145 per share. Number two, we made progress on our $25 million stock buyback program by purchasing 913,000 shares for $7 million. Number three, we completed a CLO securitization financing and our PSLF joint venture with Pantheon, which gives the joint venture ammunition to grow to about $750 million and enhance PNNT net investment income over time. Now to review the operating results. For the quarter ended March 31st, net investment income was $0.18 per share, including $0.04 per share in other income. Despite the overall choppy market, NAV was resilient and decreased by only 0.6%. The exit of Pivot was the primary reason the portfolio shrunk by $231 million during the quarter, and our leverage ratio debt-to-equity went from 1.2x down to 0.8x. Over the last couple of years, we've been targeting the reduction of the equity portion of our portfolio and using the cash proceeds to invest in loans to increase net investment income. At its peak, equity was 36% of the portfolio on March 31, 2021. The percentage of our portfolio in equity as of March 31, 2022 was down to 25%. Our long-term target continues to be 10%. With regard to net investment income, we continue to have a strategy which includes: 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 about $750 million of assets from approximately $450 million; and number three, the opportunity to rotate out of our equity investments over time and 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 successful 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 technology. These sectors have also been resilient and tend to generate strong free cash flow. As an aside, government services and defense were approximately 11.3% of the portfolio, inclusive of the joint venture and should be beneficiaries of the geopolitical environment. In many cases, we are typically part of the first institutional capital into a company where a founder, entrepreneur, or family is 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 the 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 fuels growth and helps that $10 million to $20 million EBITDA company grow to $30 million, $40 million, or $50 million EBITDA or more. We typically participate in the upside by making an equity co-investment. Our returns on these co-investments have been excellent over time; overall for our platform from inception through March 31, our $324 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.7 times. Because we are an important strategic lending partner, the process and the 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 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 loans had meaningful covenants, which helped protect our capital. This is one reason why our default rate and performance during COVID was so strong. This sector of the market, companies with $10 million to $50 million EBITDA, is the core middle market. As we just highlighted within the core middle market, we think our capital can add the most value and where we get the strongest package of risk and return is in the $10 million to $30 million EBITDA range. Our track record at PennantPark has been excellent for 15 years, but it stepped up and improved as we increased our focus on this portion of the market starting in 2015. The IRR of our investments made prior to 2015 was 9.7%. Since 2015, we have achieved a 13.7% IRR. The core middle market is below the threshold and does not compete with broadly syndicated loans or high yield markets. As many of you know, there’s been an enormous amount of capital raised by some of our large peers, and as such, they are forced to focus on the upper middle market, which are companies with over $50 million of EBITDA. Those upper middle market companies can typically also efficiently access the broadly syndicated loan market. As a result, in the upper middle market, our large peers need to aggressively compete with the broadly syndicated loan market and among themselves. This results in transactions where leverage is high, covenants are light or non-existent, spreads and upfront fees are compressed, and decisions need to be made quickly. Additionally, from a monitoring perspective, we only receive financial statements quarterly. The argument you’ll hear is that bigger companies are less risky. That is a perception and may make some intuitive sense, but the reality is quite different. According to S&P, loans to companies with less than $50 million EBITDA have a lower default rate and a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence, and intensive monitoring have been an important part of this differentiated performance. Our portfolio performance remains strong; as of March 31, the average debt to EBITDA in the portfolio was 5.1 times and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.1 times. This provides a significant cushion to support stable investment income, even when interest rates rise. We have one non-accrual on our book in PNNT and PSLF. This represents 3.5% of the portfolio at cost and 2.8% at market value. The last time PNNT had a non-accrual was December 2020. Since inception, PNNT has invested $6.8 billion with an average yield of 11%. This compares to a loss ratio of about 10 basis points annually. This strong track record includes our energy investments which are primarily subordinated debt investments made prior to the financial crisis and during the recent pandemic. With regard to RAM Energy, following a record 2021, the company continues to benefit from higher commodity prices. RAM recently drilled and completed two new wells. We are encouraged by the early flow back production results. As we anticipated, given the location of these wells, production is far more liquid-rich than prior wells RAM has drilled in this acreage. RAM expects to complete flow back procedures and report results to the Texas Railway Commission in May. With regard to the outlook, new loans in our target market are attractive with our experienced talent and our growing team. Our larger origination funnel is producing active deal flow. Let me now turn the call over to Richard, our CFO, to take us through the financial results.

Richard Cheung, CFO

Thank you, Art. For the quarter ended March 31, net investment income totaled $0.18 per share, including $0.04 per share of other income. Looking at some of the expense categories, base management fees totaled $5 million. Taxes, general and administrative expenses totaled $1.2 million and interest expenses totaled $6.5 million. Net realized and unrealized changes on investments, net of any associated tax provision, resulted in a loss of $8.7 million or $0.13 per share. We redeemed a portion of our SBA debenture, which resulted in a realized loss from debt extinguishment of $1.1 million or $0.02 per share. The change in the value of our credit facility increased our NAV by $0.02 per share. Our net investment income was in excess of our dividend by $0.04 per share. We repurchased about 900,000 shares this quarter for under NAV, adding $0.03 per share. Consequently, NAV per share went from $10.11 per share to $10.05 per share, down 0.6% from the prior quarter. As a reminder, our entire portfolio and credit facility are marked to market on ASC 820 and 825. The Board of Directors each quarter uses the exit price provided by independent valuation firms, security exchanges, and independent broker-dealer quotes when active markets are available. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value our investments. Our GAAP debt to equity ratio, net of cash, was 0.8 times. Our overall debt portfolio has a weighted average yield of 8.4%. On March 31, our portfolio consisted of 113 companies across 30 different industries. The portfolio was invested 55% in first lien secured debt, 11% in second lien secured debt, 9% in subordinated debt, including 6% in PSLF, and 25% in preferred and common equity, including 4% in PSLF. Ninety-nine percent of the debt portfolio has a floating rate, all of which has a LIBOR floor with an average LIBOR floor of 1%. Now let me turn the call back to Art.

Art Penn, Chairman and CEO

Thanks, Richard. To conclude, we want to reiterate our mission. Our goal is to generate attractive risk-adjusted returns through income, coupled with long-term preservation of capital. Everything we do is aligned to that goal. We try to find less risky middle-market companies that have high free cash flow conversion, and we capture that free cash flow primarily in debt instruments, paying out those contractual cash flows in the form of dividends to our shareholders. In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. 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.

Operator, Operator

Thank you. And we'll take our first question from Paul Johnson with KBW.

Paul Johnson, Analyst

Hi, good morning, guys or good afternoon. Hi, thanks for taking my call. Thanks for taking my questions. I'd just like to ask about the joint venture and just the decision to put a little bit more capital into the JV this quarter. I'm assuming that obviously came out of the proceeds from the large exits this quarter, and maybe just also talk a little bit about the deal opportunity set between the JV versus what goes on to the balance sheet, any differences in those two and if you're seeing one market more attractive than the other.

Art Penn, Chairman and CEO

Yes. So, thanks Paul and good afternoon. So our deal flow does generally get allocated. The JV is a mechanism for us to enhance ROE through leverage. So it's obviously mostly senior first lien loans that go into that vehicle. Equity co-invest does not go into that vehicle, so the equity co-invest stays with PNNT. So the joint venture with Pantheon takes just the first lien deals, very diversified. As we said, we did a CLO securitization financing in the joint venture this past quarter, which is really attractive long-term efficient financing and allows us to leverage the junior capital very nicely and in a safe way. So, the goal there is to take the joint venture up to about $750 million of total assets, which should be a nice enhancer to the NII of PNNT, given that it’s a little bit more leveraged than what we're doing over at the BDC itself. And of course, the co-invest sticks with the BDC. So, a nice tool for us helps us write bigger checks to these companies so that we can fuel their growth, and can be very efficiently financed. The track record so far has been very good, and I think Pantheon is pleased, otherwise they wouldn't have been willing to put additional capital in. So again, PNNT is about 60% of the capital and Pantheon is about 40% of the capital. And they're pleased so far with the performance and they're willing to continue to invest in it.

Paul Johnson, Analyst

Thanks for that. Yes, that's been a great investment for your guys and I think a pretty good way to deploy at the moment. So I appreciate that. My other question I'm hoping that you can quickly go over the non-co-investment this quarter JF Holdings, I believe that's MidOcean. What exactly is that business? And I guess what's kind of going on there? Any sort of update.

Art Penn, Chairman and CEO

Yes. So, the non-accrual is a company called Cascade Environmental, which does environmental drilling of soil. It did get impacted by COVID as drilling crews couldn't do their work and governmental entities who are a big chunk of their customers pushed things off. So, there was work to do there. It just got delayed and deferred and Omicron did not help that company either. So, there is a refinancing going on to adjust the capital structure. Our security has become a junior capital security, more like a preferred stock. The idea is to set the company up with a capital structure so that it can now grow reasonably well post-COVID. And of course, we hope to – and the sponsor hopes to look for an exit hopefully in the next year or two. So, it's been about 18 months since we had a non-accrual. So it's the first one we've had in a while. Obviously, we're not thrilled with it, but we are optimistic that over time, we can achieve an exit.

Paul Johnson, Analyst

Got it, appreciate that, and I also appreciate that your credit performance has been pretty good and there have not been many non-accruals in the recent past. Just a few more if I can as far as write-downs in this quarter just the net depreciation, how much of that reflected just kind of marking to market on loan prices during the quarter to more just sort of idiosyncratic write down this quarter?

Art Penn, Chairman and CEO

Yes. So there was a little bit of diminution in overall pricing for loans, of course, and the independent valuation firms certainly take overall market choppiness into account and then they layer that on top of the idiosyncratic, individual name-by-name performance, and come up with a blend of the two. We had a substantial markup in RAM Energy, and Pivot Physical Therapy was not fully marked the last time. So we had additional markup there as that worked towards exit. And then the markdowns were in Cascade, Jones & Frank, which you just alluded to. And, of course, this is a public stock and has been volatile. So those were the big movers both plus and minus in the portfolio from last quarter.

Paul Johnson, Analyst

Got it, appreciate that. Last question, kind of a technical one, but in the filing you give some of the abbreviated financials for RAM Energy. And I know that investment had a pretty nice markup this quarter. But I'm curious, I believe you gave the first quarter financials. What is the reason for the company being, I guess, profit negative this year, whereas I think, if I understand performance has been pretty good through last year seems to be things going pretty well this year so far. So what is the reason for just the negative profitability in this quarter?

Richard Cheung, CFO

Well, I think certainly drilling is an expense, which is the biggest expense. So as we drilled two wells, you put let's say, hypothetically, you put $20 million into drilling, into the ground, and then you hope, and I think the numbers are panning out, you hope for good cash flow back from that. So just the nature of the business, you put something out and you make your wells, and then you hopefully get the cash back in a lot more. So wells seem to be in reasonable shape; they seem to be kind of in line with the general performance of the rest of the geography. We’re more encouraged early days about the performance.

Paul Johnson, Analyst

Got it. Great. That's really good to hear on an investment that's obviously a big piece of your portfolio. So appreciate those are all my questions this morning.

Richard Cheung, CFO

Thank you, Paul.

Operator, Operator

And our next question will come from Robert Dodd with Raymond James.

Robert Dodd, Analyst

Hi. Nice simple one for you. To considerable proceeds, obviously from the very successful pivot, leverage went down, you have a lot of excess liquidity. How long do you think it's going to take you to get back closer to where you were on leverage previously? Obviously, this time it would be with income-producing assets, which could have a significant benefit on NII quite apart from the whole . So just what's – I was kidding with an easy question.

Richard Cheung, CFO

Because, Robert, you know exactly our origination flow into the future. It's a science. I'm only kidding. Look, part of it’s going to be kind of this market that we have in 2022, like, are we, I mean, we could in some sense get lucky by this might sound weird, but if our capital becomes more dear to companies, we might be able to deploy quicker at better risk adjusted returns in a choppy market, right? So we might have been lucky rather than smart to be super liquid today and have the market come our direction and have higher yields and lower risk, in which case we could deploy sooner. So far we're not seeing that, but we're only a couple, few weeks into this kind of choppy market. So in a more normal basis, I’d say kind of, I don't know, six to twelve months kind of ramping several hundred million dollars would be a six to twelve month kind of thing. And of course, we're getting repayments along the way too, and that's what happens when you pick good credits, which we never complain about. So I’d say on a normal basis, six months, maybe a little bit more might be nine to twelve months depends. Is deal flow going to slow down because of the choppiness, or are we just going to get a lot of deal flow at better risk-adjusted returns? We don't really know the answers to these questions yet. It certainly feels good to be liquid right now in an environment that looks different than it was three or six months ago. But as always, it's deal by deal, name by name, good deal comes, a good pitch comes across the play we’re going to swing. And that's how you develop these portfolios. It's hard for us to make really macro projections.

Robert Dodd, Analyst

I understand. I appreciate that. I mean, just sort of related. I mean, on the deal flow, that maybe deal memos that are coming across the desk, et cetera. I mean, it's unfair to compare to date to three months, well, like three months ago, was in 2022, but to the end of 2021 there was obviously three points. That was a crazy period. But I mean, is the – are the number of new memos coming to you depressed? Or has there been or were they depressed and they're starting to ramp back up? I mean, anything on that?

Art Penn, Chairman and CEO

Yes. Yes. So 2021 was crazy; particularly the end of 2021 was crazy. I think everyone in our business was exhausted and burnt out in some ways. Thankfully, the first quarter was light, and I think it's normalizing right now. So we are – I'd say we're kind of looking at a 2019 type pace pre-COVID for our business. We have invested in our origination platform, we have five offices across the United States. We keep investing in the team. So today we're now covering actively over 600 middle market financial sponsors. That's probably up 200 or 300 over the pre-COVID period. So we've invested in that team, in those offices, and in relationships, so that we can get more looks. The idea is to get the looks and then you have to figure out what you're seeing or not, but I'd say as a firm we're getting more looks; our origination platform is broader and deeper. We were deeper in the regions where we have the five offices and elsewhere. So the platform feels like it's good. And it feels like if we really wanted to ramp, we can do that. Of course, we need to make sure we ramp in a way where the quality is high. And that's the key and the trick in our business is to make sure the quality is high as you're ramping.

Robert Dodd, Analyst

Understood. I appreciate, and again, congratulations on the quarter and the shape of the business and being liquid right now.

Art Penn, Chairman and CEO

Thank you, Robert.

Operator, Operator

And our next question will come from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Yes, good afternoon, Art and Richard. Just a couple of questions for me. Art, we've talked about RAM Energy, obviously a lot in the past. So my question today is simply what do you think it's going to take for M&A in the oil and gas sector to pick up and potentially more positively impact RAM's valuation? Is it a situation where folks are just gun shy and they don't believe these prices are sustainable, or what's holding things back?

Art Penn, Chairman and CEO

It's a great question. We are – right now there is not a middle market M&A wave for oil and gas. We are starting to see some small trades, not too far from our geography, which is promising. So that's point number one. Point number two is you’re still in a timeframe where if you're a seller, you still are modeling $100 oil and $7 or $8 gas. And if you're a buyer, you're thinking you should be buying off $70 oil and $4 or $5 gas, right? So, there's still a gap over time. That'll collapse and will be an equilibrium. And I want to be clear here at PennantPark, we're not holding out for the last nickel or dime to sell RAM. We would want an efficient process, a process that gets fair value. So, we're – as soon as it makes sense. And as soon as there is a bit of M&A activity where buyers and sellers are coming together in a reasonable timeframe, we will start to assess options. We're not quite there yet. In the meantime, we're heads down focused on completing these wells, optimizing the output and getting ourselves organized, and getting the numbers put together and getting the engineering reports and setting ourselves up to have hopefully interesting conversations in the not too distant future. So, we'd still look to get out in a reasonable timeframe at a fair price. And in the meantime, as long as you can make good investments and get good returns, that's not a bad backup strategy. Not our top strategy, but not a bad backup strategy if things don't go the way we'd like.

Mickey Schleien, Analyst

Thanks, Art. That's really helpful. In the past, you've talked about RAM has a loan from the federal government. I think it was under the Main Street lending program. And there's a potential, I guess, to refinance that and maybe liberate some cash for Pennant. Is that still on the cards, or given where the markets are, that's completely off the table?

Art Penn, Chairman and CEO

That's possible. I mean, I think again, we want to execute on these wells, get the cash flow, and it's possible that towards the end of the year, we might be able to take it out. Again, all these processes may come together where we're evaluating strategic options, we're evaluating our financing options. And we hope to have enough cash in the till towards that end of the year to potentially refinance that, take it out. And yes, that would be one avenue for liberating cash for PNNT shareholders.

Mickey Schleien, Analyst

Okay, that would be great. Just last question, sort of housekeeping, maybe for Richard, where does the pivot exit leave the fund in terms of undistributed net capital gains if any on a tax basis?

Richard Cheung, CFO

We don't – we're in a net capital loss situation from a tax basis even with the pivot transaction. So what we expect to just NII? We do have $0.52 per share of undistributed net investment income.

Mickey Schleien, Analyst

Did you say 52?

Richard Cheung, CFO

Fifty-two, correct.

Mickey Schleien, Analyst

Okay. Thank you for that. That's it for me. Thank you.

Richard Cheung, CFO

Thank you.

Operator, Operator

And our next question will come from Melissa Wedel with JPMorgan.

Melissa Wedel, Analyst

Good afternoon. Appreciate you taking my questions today. You've actually answered a lot of mine already, but I was hoping to just get your thoughts at a high level about the volatility that we've seen in the forward curve and how you're thinking about both your portfolio investments but also the broader market and what trade-offs there might be between sort of higher investment income from those floating rates moving higher and what offset there could be on the credit side of things and companies' ability to really digest those borrowing costs.

Art Penn, Chairman and CEO

Great question. And it's something we all need to be modeling in even more so in the coming environment, company's ability to weather higher interest rates. As I said, the average EBITDA to interest ratio we have today is 3.1 times at PNNT. So I think we feel pretty good that even if rates go up at PNNT, we've got substantial cushion. That said, your point's an excellent one. I think we have to take it even more seriously in modeling and projecting going forward in our cases and investment committee memos. Higher interest rates would lead you to – it could lead you to which I think we've always had this discipline of keeping our leverage levels reasonable. Here in this portfolio, we're about 5.1 times debt to EBITDA. We – that's a comfortable zone for us. We don't like high debt EBITDA multiples because it's just more burden that the company has to bear. So we are still oriented to cash flow. We're still oriented to free cash flow and getting paid down. I mean, there are a lot of other people who are doing deals based on recurring revenues where there's not EBITDA, and those have worked so far. But we are certainly in choppier waters and we need to maintain our prudency and maybe even double down on that in this choppier environment.

Melissa Wedel, Analyst

Art, do you think that that could impact the opportunity set for you too? Is there a – I know the portfolio is almost essentially nearly entirely floating rate. If there's demand from companies to lock in some financing costs at a fixed rate, but perhaps at better spread, is that something that your team would be thinking about?

Art Penn, Chairman and CEO

Sure. I mean, look, we like to think we're economically rational, as we like to think. I believe we are the vast majority of the time. But yes, if there's a time when we started out 15 years ago, we did a lot of mezzanine debt, which was, and still is not that there’s a lot of it going on, fixed rate kind of teens type of capital. So for the right credits, for the right structure, the right call protection, the right co-invest package, the right covenant package, we should be willing to trade that off. We don’t come at it with an absolute view that we don’t do fixed rate. With the right set of circumstances, I think we’d be open to that.

Melissa Wedel, Analyst

Are you seeing demand for that from borrowers yet?

Art Penn, Chairman and CEO

Not yet. I mean, there might be a deal or two in our pipeline that looks like that kind of what we would call traditional mezzanine. But it could come back. You're right in this environment; there might be more demand for back-to-the-future kind of structures. We've had a good – we know what we're doing in that world and got a good track record. So again, opportunistically, and in PNNT, this would be the place to do that versus PSLF opportunistically for the right kind of teens return. We would be open to that.

Melissa Wedel, Analyst

Thanks, Art.

Art Penn, Chairman and CEO

Thank you.

Operator, Operator

And that does conclude the question-and-answer session, and now turn the conference back over to Mr. Art Penn.

Art Penn, Chairman and CEO

Thanks everybody for listening in today. We appreciate your focus on us. Our next quarterly earnings will be in early August, and we look forward to speaking with you then. Thank you. And that does conclude today's conference. We do thank you for your participation. Have an excellent day.