Earnings Call Transcript - PNNT Q3 2022

Operator, Operator

Good afternoon, and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2022 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.

Arthur Penn, Chairman and CEO

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's Third Fiscal Quarter 2022 Earnings Conference Call. I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Richard Allorto, 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 that 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 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.

Arthur Penn, Chairman and CEO

Thanks, Rick. And I'd like to welcome you as the new CFO of our BDCs. We're going to spend a few minutes and comment on our target market environment, provide a summary of how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open up for Q&A. From an overall perspective in this era of inflation, rising interest rates, and geopolitical risk, we believe we are well positioned as a lender focused on the United States, where floating interest rates on our loans can protect against rising interest 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 well positioned as a company that has a clear game plan for growth of net investment income and dividends. We continue to execute on our plan to increase long-term shareholder value, and I'm pleased to announce that the Board of Directors has approved another increase of our quarterly dividend to $0.15 per share payable on October 3 to shareholders of record as of September 19. Additionally, we continued buying shares under our stock buyback program and purchased approximately 718,000 shares during the quarter for $5 million. The purchases were accretive to NAV by $0.03 per share. In total, we have bought back $12 million or 1.6 million shares. Some highlights for the quarter ended June 30 were as follows: we recorded an additional net unrealized gain of $12 million or $0.19 per share on our equity investment in RAM Energy. RAM continues to expand operations and drilling, and our equity investment increased in value from the prior quarter. We expect RAM to explore strategic options in the coming quarters. Number two, after quarter end, we completed the amendment, extension, and expansion of the Truist Credit Facility. The size increased from $465 million to $500 million, and the maturity was extended 3 years until 2027. Thank you to our lending partners for their confidence and support of the company. Number three, we continue to grow our PSLF JV. The JV grew from $446 million to $608 million during the quarter and continues to generate an attractive double-digit ROE for PNNT. Subsequent to quarter end, the JV has continued investing and growing its investment portfolio. And PNNT and Pantheon Ventures increased their capital commitments to the JV by $76 million. We are targeting a $1 billion vehicle over time, which can drive substantial growth in NII at PNNT. With the rise in base interest rates, PNNT is well positioned to grow NII as 96% of the debt portfolio is in floating rate assets. Holding everything else constant in the portfolio, a 1% increase in base rates should increase NII by $0.02 per share per quarter and a 2% base rate increase would result in a $0.04 per share per quarter increase. The choppier market is creating what looks to be an attractive vintage of new loans for the remainder of 2022 and 2023. In the last couple of months, we have seen spreads widen out approximately 100 basis points, an increase in upfront fees or original issue discount, lower leverage and tighter covenant packages. Now to review the operating results. For the quarter ended June 30, the net investment income was $0.16 per share including $0.02 per share in other income. During the quarter, we placed our investment in MailSouth on nonaccrual as a result of continued underperformance. Our GAAP NAV decreased by 4%, driven primarily by a decrease in investment valuations. The decrease was largely attributed to mark-to-market adjustments resulting from the overall choppy market as opposed to specific credit-driven items within the portfolio. We increased the investment portfolio by $101 million during the quarter, and our leverage ratio, or debt to equity, increased from 1.16x, up from 0.8x. Regarding increasing net investment income, our strategy remains focused on: number one, optimizing the portfolio and balance sheet at PNNT as we move towards our target leverage ratio of 1.25x debt to equity; number two, growing our PSLF JV with Pantheon to $1 billion of assets from approximately $608 million of assets at quarter end; and number three, rotating out of our equity investments over time and redeploying the capital into cash pay yield instruments. We have a long-term track record of generating value by successfully financing high-growth middle-market companies in 5 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 technology. These sectors have also been resilient and tend to generate strong free cash flow. As an aside, government services and defense is approximately 10% of the portfolio inclusive of the JV and should be a beneficiary 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 are 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 the 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, for the platform from inception through June 30, our $335 million of equity co-investments have generated an IRR of 28% at a multiple on invested capital of 2.5x. 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 upfront fees, 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 have meaningful covenants, which help 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 of EBITDA, is the core middle market. Within the core middle market, we think our capital can add the most value, and we believe the opportunity to get the strongest package of risk-return is in the $10 million to $30 million of EBITDA range. The core middle market is below the threshold and does not compete with the broadly syndicated loan 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 nonexistent, spreads and upfront fees are compressed and the decisions need to be made quickly. Additionally, from a monitoring perspective, they generally 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 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. Borrowers in our investment portfolio are performing well and we believe are well positioned for future quarters. As of June 30, the weighted average debt-to-EBITDA in the portfolio was 4.4x. And the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.7x. This provides substantial cushion to support stable investment income even when interest rates rise. Based on this substantial cushion, even with a 350 basis point rise in base rates and flat EBITDA, our portfolio companies will cover their interest 2.2x on average. As of June 30, we had one nonaccrual on our books in PNNT. This represents 0.9% of the portfolio cost and 0.5% of the portfolio market value. Since inception, PNNT has invested $7.2 billion at an average yield of 11%. This compares to a loss ratio of approximately 9 basis points annually. This strong track record includes our energy investments primarily subordinated debt investments made prior to the financial crisis and recently, during the pandemic. With regard to the outlook, new loans in our target market are attractive, and this vintage should be particularly appealing. Our experienced and talented team and wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors. We want to reiterate our mission. Our goal 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 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.

Richard Allorto, CFO

Thank you, Art. For the quarter ended June 30, net investment income totaled $0.16 per share, including $0.02 per share of other income. Operating expenses for the quarter were as follows: base management fees were $4.9 million, interest expense was $6.7 million, general and administrative expenses were $1 million, and provision for taxes were $0.2 million. For the quarter ended June 30, net realized and unrealized change on investments, including provision for taxes, was a loss of $29 million or $0.44 per share. Provision for taxes of $8 million or $0.12 per share was due primarily to the increase in the value of RAM Energy. The change in the value of our credit facility increased our NAV by $0.14 per share. Our net investment income was in excess of our dividend by $0.015 per share. We repurchased approximately 718,000 shares during the quarter at an average purchase price of $6.91, resulting in accretion to NAV of $0.03 per share. As of June 30, our NAV per share was $9.65, which is down 4% from $10.05 per share from the prior quarter. Our GAAP debt-to-equity ratio net of cash was 1.16x. As of June 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 118 companies across 31 different industries. The portfolio was invested in 55% first lien secured debt; 10% in second lien secured debt; 9% in subordinated debt, including 6% in PSLF; and 26% in preferred and common equity, including 4% in PSLF. The weighted average yield on debt investments was 9.3%. 96% of the debt portfolio is floating rate with an average LIBOR floor of 1%. As base interest rates rise, we are well positioned to participate on the upside. Holding everything else constant in the portfolio, a 1% increase in base rates translates into $0.08 per share of NII upside per year, a 2% increase translates into a $0.16 per share increase in NII per year. Now let me turn the call back to Art.

Arthur Penn, Chairman and CEO

Thanks, Rick. 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'd like to open up the call for questions.

Operator, Operator

And we will go to our first question from Paul Johnson of KBW.

Paul Johnson, Analyst

As far as RAM Energy goes, I'm just curious, when you say you're exploring strategic alternatives for the company, I'm just curious, what's the difference between, I guess, what you're doing now with the company versus prior getting the company ready for sale?

Arthur Penn, Chairman and CEO

Thank you for the question, Paul. RAM has been performing exceptionally well. Recently, the well performance has been strong, and they have an impressive track record in East Texas. Given the current oil and gas prices and the company's operations, we believe it is the right time to look into strategic options. Specifically, I wanted to mention these last two wells that we drilled, which have yielded great results, reaffirming the quality of our acreage and the opportunity ahead. With these two wells, we are putting together a package that is even more appealing to potential buyers.

Paul Johnson, Analyst

Got it. And so does that mean have you guys retained like any firm to assist in that sale and look for options? Or is this just more essentially that's basically officially on the block for sale?

Arthur Penn, Chairman and CEO

Yes. I think I'll just reiterate, we're going to explore strategic options over the coming quarters. I think I want to just leave it at that at this point.

Paul Johnson, Analyst

Got it. I appreciate that. My next question is about the interest income for the quarter. I'm curious why it was down or roughly flat compared to the prior quarter given all the net growth this quarter. Was that due to a timing issue or was the nonaccrual what drove that?

Arthur Penn, Chairman and CEO

We did have one non-accrual, and we were very active, especially towards the end of the quarter. I believe those two factors balanced each other out. We are well positioned as we approach our target debt-to-equity ratio of 1.25x. The joint venture at PNNT is experiencing growth, and base rates like LIBOR and SOFR are also increasing. Therefore, we are optimistic about potential revenue growth and interest income this quarter.

Paul Johnson, Analyst

Got it. Appreciate that. And then you mentioned that you get monthly financial statements from your portfolio companies, gives you a snapshot of the ongoing performance, I guess, for the year. I'm curious, do you also receive any sort of updated forecast for the businesses throughout the year? Or if you had conversations, I guess, with sponsors? I'm just curious how those conversations, if you've had them, how they've gone and have things changed? Is there more pressure on businesses to cut costs, that sort of thing? Anything that you've seen there?

Arthur Penn, Chairman and CEO

Yes. We're clearly in a different economic environment compared to the post-COVID period. Our management teams recognize that the economic landscape has changed. Beyond interest rates, certain aspects of the economy are under closer scrutiny. Competent executives are being very realistic about the situation and are diligently working to optimize their revenues and cost structures. As lenders, we're okay with flat growth, but we're still seeing reasonable growth overall. From our perspective, we have strong cash interest coverage and sufficient cushion, primarily with first-lien and some second-lien debt securities. We believe the environment is satisfactory. We're also optimistic about the upcoming vintage for late 2022 and 2023, which appears promising. Leverage levels are decreasing, spreads are widening, and capital availability is tighter, making covenants more significant. Our due diligence can be more comprehensive, and the risk-adjusted returns in this new environment should be favorable. With good prior vintages rolling off, if we manage our underwriting effectively, we expect to see payoffs, even in the current environment. We'll reinvest those proceeds into the upcoming vintage, which looks to be very promising.

Paul Johnson, Analyst

Got it. Last question for me. I'm asking about one loan in the portfolio. This one stood out to me as it marked a little bit lower, still at 88% of cost for AKW Holdings. I'm curious if you can provide any insights on that description given its size.

Arthur Penn, Chairman and CEO

I believe the mark is primarily due to the British pound sterling, as this is our only U.K. company. You may have noticed an offsetting gain from our borrowing in pounds. We have a U.K. company and borrow in pounds, which provides some hedging. However, if you exclude the currency impact, the credits would stand at par value.

Operator, Operator

We'll hear next from Robert Dodd with Raymond James.

Robert Dodd, Analyst

Going back to one of Paul's questions, regarding the timing of deployments, I noticed that while the portfolio did expand, the interest income did not increase significantly. Were the deployments timely during the quarter, or were there early repayments? Was there anything unusual this quarter, or was it just typical inter-quarter activity?

Arthur Penn, Chairman and CEO

Yes, we consider it a fairly typical active quarter. Base rates like LIBOR and SOFR began to rise significantly towards the end of the quarter. We ended with a solid underlying LIBOR base rate of around 1.8% or 1.9%, which is an increase from the 1% minimum we had last quarter. This uptick is largely attributed to the movement since the quarter ended. There isn't much else of note to discuss, aside from one small non-accrual and the increase in base rates.

Robert Dodd, Analyst

Got it. On the joint venture, I have a couple of questions. First, it currently holds $600 million in assets, and you plan to increase it to $1 billion. You own 60% of that. It's almost doubled in size over the last two years. Is that the kind of growth rate you are comfortable with, or when do you anticipate reaching that target size, especially now that deploying capital might be more appealing in a wider spread environment?

Arthur Penn, Chairman and CEO

Yes, that's a valid point, and we are pleased with the current conditions we are encountering. I would estimate that it will take about a year on the shorter end and possibly up to two years on the longer end. We are aiming to reach that $1 billion target within the next 12 to 24 months.

Robert Dodd, Analyst

Got it. Regarding the dividend, it remained flat sequentially, but based on my calculations, the dividend relative to the net interest income seems to be about 75%. However, it appears that you are only owning a portion of that, which suggests that this year, the distribution might be exceeding the earnings. Is my calculation accurate? Can you provide insight into why this might be happening? Is it possible there's an accumulation of retained earnings from the past? Will this trend continue in the future?

Arthur Penn, Chairman and CEO

Yes, we experienced some significant early successes. We believe that the junior capital we are investing, which includes both subordinated debt and equity, should yield around a 13 percent return. Our goal is for that to increase over time, which is one of the reasons we've surpassed $600 million and have continued to grow since the end of the quarter. Pantheon and I have agreed to invest more junior capital into the enterprise to optimize our return on equity. To reach $1 billion, we will likely need to use CLO technology again, which we find effective for these first lien low-risk assets due to its financing efficiency and long-term nature. Currently, we have one middle market CLO in play and may pursue another in the future. I anticipate a gradual approach over the next 12 to 24 months, although it could happen sooner given the attractive market conditions, which may lead us to accelerate our plans. We now have the capital and a strong partnership with Pantheon, and as PNNT becomes more optimized in terms of debt and equity, we will be able to rotate out older deals and invest in new opportunities within this favorable market. Our strategy includes several methods for increasing income. With rising LIBOR rates, we can identify four primary ways to boost income for PNNT, which gives us considerable confidence. We are optimistic that all four avenues will be realized: base rates are certainly increasing, spread widening is occurring, we hope to rotate equity successfully, and we are confident in the growth of our joint venture. These are the tools we have to enhance our performance, and we expect to capitalize on them to increase net investment income over time.

Robert Dodd, Analyst

Congrats on the quarter and the dividend increase again.

Arthur Penn, Chairman and CEO

Thank you.

Operator, Operator

We will now turn to Mickey Schleien of Ladenburg Thalmann.

Mickey Schleien, Analyst

Art, just as a housekeeping question, did you reverse any previous accruals of income for MailSouth this quarter?

Arthur Penn, Chairman and CEO

No.

Mickey Schleien, Analyst

Okay. I have a broader question. Given your experience in the credit markets, I wanted to ask you a high-level question. Loan prices are weak, and credit spreads are widening. GDP growth has been negative, which presents several challenges. However, looking back at previous earnings calls and considering the published data on leveraged loans, credit does not seem to be deteriorating significantly from a high level. There are certainly unique issues at play. It almost feels like there is a market illusion occurring, or that credit issues may arise later this year or next year. The current spreads and NAVs might be more justified. What is your perspective on the outlook for the remainder of this year and into next year?

Arthur Penn, Chairman and CEO

That's a good question. It really comes down to what's in the underlying portfolios of our BDCs and others in the industry. Many of us have been around for a while and focus on industries that can withstand a recession. Anyone experienced in our field includes a recession scenario in their analysis. These loans have a duration of 5 to 7 years, so considering a recession is essential. We aim to build portfolios that are resilient and resistant to recession. We prefer industries like healthcare, defense, and government services because we see them as stable even in tough economic conditions. However, if you look at the leveraged loan index or the high-yield index, you'll find industries that are inherently more cyclical. For example, during COVID, BDC credits and direct lending performed better than the high-yield index largely because we don't invest heavily in sectors like airlines or energy, which are more cyclical. Our focus on sectors less affected by economic fluctuations is one reason we fared better than the overall credit markets. Now, as we face what appears to be a typical recession, it may have unique aspects. We anticipate an economic slowdown, and we analyze the potential impacts, such as how a reduction in EBITDA would affect us. During the recession following the global financial crisis, EBITDA decreased by 7%, which was our worst-case scenario then. While this recession might not be as severe, it still has the potential to be challenging. We've designed our portfolios with significant buffers, intending for them to resist recessionary pressures. That's likely contributing to the confidence you sense from us and our colleagues in this industry since we're strategically positioned for this type of economic environment.

Mickey Schleien, Analyst

Yes, I appreciate that and I agree with you. And I guess my follow-up would be that given your remarks just now, a lot of the depreciation we've seen in NAVs this quarter, maybe the previous quarter have just been technical because of spreads widening. It sounds to me that we may see some of that in Pennant's case reverse over time as these credits mature and you pay back at par. Is that a reasonable assumption on our behalf as it relates to PNNT?

Arthur Penn, Chairman and CEO

Yes. That's right. The credit book is down kind of in line with the industry. It's the loans were marked down a point or 2 based on the market, not necessarily on credit performance. The bigger moves in NAV were due to our equity portfolio, which, by definition, should be a little bit more up and down because it's equity. So the big movers in our portfolio PNNT were mostly some of our equity investments.

Operator, Operator

We'll go next to Casey Alexander with Compass Point.

Casey Alexander, Analyst

Let me rephrase Mickey's question in a different way. The current period of economic uncertainty, which some refer to as a recession, seems quite different from last year. The great financial crisis was a huge shock to the system, and COVID hit us almost overnight with widespread business closures. In contrast, this slowdown appears to be driven by the Federal Reserve's efforts to control inflation. Does this allow your portfolio companies, given the Fed's signaling, a better chance to prepare by strengthening their balance sheets, reducing expenses, and aligning inventory levels with anticipated demand during this economic downturn? Is this an advantage for your companies in this particular cycle?

Arthur Penn, Chairman and CEO

Yes, definitely. COVID was a sudden disruption. Whether it can be classified as a true recession is up for debate, but it certainly happened quickly. Our companies performed reasonably well during COVID largely due to the experience of the sponsors and management teams who had faced the global financial crisis. That crisis was also a surprise, but it unfolded more gradually, culminating in a significant shock in September 2008. A key lesson learned from that experience was the importance of acting swiftly to reduce expenses, manage capital expenditures, and handle working capital effectively. Companies that were slow to respond during both the post-GFC recession and COVID faced challenges. In contrast, the rapid action taken by our companies during COVID was impressive and beneficial. You're correct that this situation may be more predictable, even if it unfolds slowly, giving companies time to anticipate changes and make necessary adjustments to their expenses and working capital management. It seems like consumer behavior is changing, as they shift spending from goods to travel and experiences. Since consumers are a significant part of the U.S. economy, these trends will have far-reaching effects, although some sectors like defense and healthcare may be less impacted. We are closely monitoring monthly data and keep in regular communication with our companies, which allows us to prepare and assist them during these times.

Casey Alexander, Analyst

Right. Secondly, I appreciate your comments about the strategic option for RAM. I think most of us who are listening to the call are centered pretty much on the sale of RAM. But maybe you could outline what some of the other potential strategic options are for RAM and how those might benefit shareholders?

Arthur Penn, Chairman and CEO

That's a great question. RAM is generating good cash flow, and the wells have been successful with attractive prices for oil and natural gas. There are various options available. We can continue operating the company, generating cash flow, and paying down the Main Street loan. If it makes sense, we can drill more wells that show a good return on investment. Cash flow can be distributed to our shareholders in different ways. While there is a focus on strategic options including the potential exit, there are also other appealing choices based on the returns that the company can achieve with its current capital expenditures, which should create value and cash flow for our shareholders.

Casey Alexander, Analyst

Okay. Well, and lastly, I think shareholders do appreciate certainly the return of capital and share repurchase programs when the stock is trading at 65% of book. It's hard to replicate that in your own investing opportunities. So I would wonder if the Board would at least reload the plan when it fills up or if not even that 65% of book accelerate the plan. You've done a lot of good things in terms of working down some of the equity portion of the portfolio. And certainly, if RAM comes off, what are the hopes of perhaps accelerating that to some extent?

Arthur Penn, Chairman and CEO

Yes, that's a great point. We're committed to this kind of program, and this is our third buyback. We have a strong track record and will continue to pursue this strategy if necessary. You're also correct that if we can achieve some favorable exits, that could help speed things up.

Operator, Operator

And with no further questions in queue, I will now turn the conference back over to Art Penn for any additional or closing remarks.

Arthur Penn, Chairman and CEO

Just want to thank everybody for being on the call today. A reminder that this next quarter is our fiscal year-end, September 30 is our fiscal year-end. So we'll be filing our 10-K, and that will happen kind of in mid-November. So a little later than our normal Qs. Our 10-K will be filed in mid-November. We look forward to talking to everybody at that point in time. And again, Thanks, everybody, for participating. Everyone, have a great rest of the summer.

Operator, Operator

And that does conclude this call. Thank you for your participation. You may now disconnect.