Earnings Call Transcript - PNNT Q3 2024

Operator, Operator

Good afternoon, and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2024 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.

Art Penn, Chairman and CEO

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's third 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.

Rick 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. An audio replay of the call will be available on our website. I'd also like to call your attention to the customary safe harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at pennantpark.com or call us at (212) 905-1000. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Art Penn, Chairman and CEO

Thanks, Rick. We're going to spend a few minutes commenting on the current market environment for private middle-market credit, how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, and then open it up for Q&A. For the quarter ended June 30, our GAAP net investment income was $0.24 per share and our core net investment income was $0.21 per share. GAAP and adjusted NAV decreased 2.2% to $7.52 per share from $7.69 per share. The decrease in NAV for the quarter was due primarily to valuation adjustments on the non-accrual loans, partially offset by increases in several equity investments. As of June 30, our portfolio totaled $1.2 billion. During the quarter, we continued to originate attractive investment opportunities and invested $163 million in 11 new and 42 existing portfolio companies at a weighted average yield of 12%. We continue to see an attractive vintage in the core middle market. For investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.4x, the weighted average interest coverage was 1.9x, and the weighted average loan-to-value was 50%. As of June 30, the portfolio's weighted average leverage ratio through our debt security was 4.3x and the portfolio's weighted average interest coverage was 2x. These attractive credit statistics are a testament to our selectivity, conservative orientation, and our focus on the core middle market. During 2024, the market yield on first lien term loans has tightened 50 to 75 basis points. As the credit statistics highlight, we continue to believe that the current vintage of core middle-market directly originated loans is excellent. In the core middle market, leverage is lower, spreads are higher, and covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market and the core middle market, we're still getting meaningful covenant protections. At June 30, the JV portfolio equaled $926 million. During the quarter, the JV invested $56 million, including $38 million of purchases from PNNT. During the quarter, the JV made a special dividend of $4.2 million and PNNT's share was $2.5 million. The dividend was the distribution of the JV's cumulative undistributed net investment income; the special dividend is another indicator of the earnings power of the JV. With its current capital base, the JV portfolio can grow to $1.1 billion. We're having discussions with our JV partner to potentially grow the JV. Over the last 12 months, PNNT earned a 19.5% return on invested capital in the joint venture. We expect that with continued growth in the JV portfolio, the JV investment will enhance PNNT's earnings momentum in future quarters. Credit quality remained strong. We had three non-accruals as of June 30. Non-accruals represented 4.2% of the portfolio cost and 2.5% at market value. Now let me turn to the current 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 to our borrowers. We have a long-term track record of generating value by successfully financing growing companies in five key sectors. These are sectors where we have substantial domain expertise, have the right questions to ask, and have an excellent track record. These sectors include 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 includes companies with $10 million to $50 million of EBITDA, is below the threshold and does not compete with the broadly syndicated or high-yield markets, unlike our peers in the upper middle market. In the core middle market, we are an important strategic lending partner; the process and packaging terms we receive are attractive. We have many weeks to conduct our due diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, and equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. Regarding covenants, unlike the erosion of the upper middle market, virtually all of our originated first lien loans have meaningful covenants to help protect our capital. This is a significant reason why we believe we're 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 may seem intuitive, 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 a higher recovery rate than loans to companies with higher EBITDA. We believe the meaningful covenant protections of core middle market loans, coupled with 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 June 30, we have invested over $511 million in equity co-investments and have generated an IRR of 26%, resulting in a multiple on invested capital of 2x. Since inception nearly 17 years ago, PNNT has invested $8.2 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of about 20 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. Regarding the outlook, new loans in our target market are attractive. Our experienced and talented team and our wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors. We want to reiterate our goal to generate attractive risk-adjusted returns through income, coupled with long-term preservation of capital. We seek to find investment opportunities in growing middle market companies with high free cash flow conversions, capturing that free cash flow primarily in debt instruments, and paying 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.

Rick Allorto, CFO

Thank you, Art. For the quarter ended June 30, GAAP net investment income was $0.24 per share and core net investment income was $0.21 per share. During the quarter, we received a special dividend of $2.5 million, or $0.03 per share, from the JV, which consisted of cumulative undistributed net investment income from prior periods. Given the nonrecurring nature of this dividend, we have excluded it from our core net investment income. Operating expenses for the quarter were as follows: interest and credit facility expenses were $11.5 million, base management and incentive fees were $7.5 million, general and administrative expenses were $1.5 million, and provision for excise taxes was $0.7 million. For the quarter ended June 30, net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $12 million. As of June 30, our GAAP and adjusted NAV was $7.52 per share, which is down 2.2% from $7.69 per share in the prior quarter. As of June 30, our debt-to-equity ratio was 1.5x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of June 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 144 companies across 30 different industries. The weighted average yield on our debt investments was 12.7%. We had three nonaccruals, which represent 4.2% of the portfolio at cost and 2.5% at market value. The portfolio is comprised of 56% first lien secured debt, 5% second lien secured debt, 10% subordinated notes to PSLF, 4% other subordinated debt, 6% equity in PSLF, and 19% in other preferred and common equity. Ninety-six percent of the debt portfolio is floating rate. Debt-to-EBITDA on the portfolio is 4.3x, and the interest coverage ratio is 2.0x. Now let me turn the call back to Art.

Art Penn, Chairman and CEO

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, and I would like to open up the call to questions.

Operator, Operator

We'll take our first question from Mark Hughes with Truist.

Mark Hughes, Analyst

The return potential you described it very good, the 19.5% return on invested capital in the JV. If you increase the size of that as apparently you're discussing, how does that change the return profile? And is that level of return sustainable?

Art Penn, Chairman and CEO

Mark, it's Art. Good question. Look, certainly, the returns of these vehicles, the BDC itself, and the JV are high now. We've been in a high interest rate environment. So I would say to the extent that interest rates start to come down, yields will come down across the platform in the BDC as well as the JV. Today, we've had a really good credit performance in that JV. There's never an assurance that we'll continue that, but we're very pleased with the upper teens. I think if you want to model it, you can certainly project it into the upper teens. And to the extent we finalize the arrangement to upsize the JV, whatever capital PNNT puts in, you can certainly model it with an attractive return on that capital, which should certainly be accretive to PNNT.

Mark Hughes, Analyst

And then the dividend trajectory, you had a special dividend this quarter; obviously, refresh me on how that has trended over time, what the usual pacing has been on those sorts of dividends.

Art Penn, Chairman and CEO

Yes. Rick will provide the historical data. Typically, we take the net interest income for the joint venture and distribute most of it while keeping a small reserve that accumulates over time. We distributed about $0.03 per share because we wanted to distribute all the undistributed income as we consider expanding the joint venture. So everyone has a clean start. Rick, what has been the history?

Rick Allorto, CFO

Yes. So Mark, the regular core dividend from the JV is about $4.8 million in the quarter.

Mark Hughes, Analyst

Yes, yes. And then the equity co-invest, is that something where you might think about either increasing or decreasing the pacing, as your experience recently been kind of more or less favorable in historical terms? And does that influence your appetite on a go-forward basis?

Art Penn, Chairman and CEO

That's a great question. For us, it's usually less macro and more micro. We're looking at the particular companies, the investments, the entry multiples, and the growth parameters. Prototypical deals for us start with a company that's doing $10 million to $20 million of EBITDA. The sponsor has a growth trajectory in mind. There's a delayed draw term loan. We're helping fuel that growth. So the goal is to take that $10 million to $20 million EBITDA company and grow it to $30 million, $40 million, $50 million and above with our debt capital being a driver of that. So in many cases, it makes sense for us to participate in some of that equity by co-investing side-by-side with the sponsor. These are not intended to be large equity bets; they are generally meant to be a relatively small amount, but over time, 5% to 10% to maybe 15% of the portfolio.

Operator, Operator

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

Robert Dodd, Analyst

First one, I may have missed this. There's been a lot of color. On the JV, you just to mark it, are you paying out the excess so that as it gets upside, everybody comes in at the same level, so can I read into that there's the intent to maybe not just upsize it with the existing partner, but is there an intent to maybe expand the number of partners that are involved in that JV?

Art Penn, Chairman and CEO

Yes, that's a good question. It's working really well with our existing JV partner. It's been great synergy. We started with them right after COVID, and now we are about three or four years in. I think if we had another third-party, we would probably set up a separate JV. Once you start getting more different decision-makers around the table, it complicates things, and each JV partner has their own way of thinking about things, etc. So I think we're open to another JV over time if we can find the right partner who sees credit the way that we see it and shares our perspective. So that's certainly potentially on the table for PNNT.

Robert Dodd, Analyst

On the market outlook, do you expect the recent volatility to impact demand in your area? While there have been some large market BSLs pulled, that’s not where you typically compete. If the volatility continues, do you think it will influence sponsor activity in your segment? What are your thoughts on how things are developing?

Art Penn, Chairman and CEO

Yes. When you look back over many years, and we've been at PennantPark now for 17 years, when you have market shocks, it takes a little while for the core middle market to respond. First, obviously, the broadly syndicated loan market reacts fairly immediately, which then impacts the upper middle market, and that subsequently affects the core middle market where we operate. Typically, it takes up to six months of a choppy market before it starts impacting our market. What are we supposed to do in the meantime? We can wait. We're never in a rush to invest. We've learned lessons over the years that you should never rush to invest. So we're not in a rush to invest. On the other side, when you find great companies and great capital stacks, it's always a good time to invest because we feel that great companies and great situations end up working out no matter the scenario. If this choppiness continues, we are certainly going to be considering the macro and seeing what's happening, but we're also going to be as always, looking at the micro and trying to find excellent companies that we can back and support excellent sponsors while navigating both sides.

Robert Dodd, Analyst

Yes, I think I understand your general idea. Again, on the non-accrual or new non-accruals, there was a new non-accrual last quarter. Flock has been restructured and their debt is back on accrual in one quarter. You had another new non-accrual this quarter. I mean is this a similar situation where it's going to be very short term and a quick restructuring, or can you give us any color on what you expect kind of the timeline for this compared to last quarter?

Art Penn, Chairman and CEO

Yes. Yes, with Flock, that was a restructuring. We converted debt to equity. We injected more money into it, and we now control the company. This new non-accrual, called Pragmatic, provides corporate training solutions to product managers across technology and other industries. The sponsor injected equity underneath us, which makes this situation a bit different. The sponsor provided equity, and we are not in control at this point. The valuation came in low, in the low 60s, and it's a PIK (Payment-in-Kind) instrument. Given the valuation came in the low 60s and it’s PIK, we decided to put it on non-accrual ourselves.

Operator, Operator

We'll take our next question from Paul Johnson with KBW.

Paul Johnson, Analyst

You guys seem to be approaching maximum leverage on the balance sheet and on the BDC, and also the JV at least kind of the informal sort of market side. I think you had mentioned on previous calls for the JV. I know you're obviously, potentially in discussions to expand that as well. But can you just kind of talk about your investment capacity here as we sit at kind of 1.5x leverage? Should we expect to see kind of a pullback here a little bit and focus on just recycling capital at this point?

Art Penn, Chairman and CEO

Yes, Paul, that's a great question. I think that's a fair statement; we are at full leverage now. We're going to use the JV to deleverage—that's the first thing we're going to do. Over time, we do expect and hope to see some rotation on the equity portfolio as M&A activity starts to pick up. There are some really interesting equity positions in there, so we're very hopeful that we can rotate some of the equity, which will create dry powder to invest in cash-paying debt securities.

Paul Johnson, Analyst

And then I realize, I mean, the portfolio overall hasn't experienced a ton of spread compression, but I mean, within the JV, have you seen any spread compression there? Should we temper expectations for kind of these additional special dividends and maybe the overall return on JVs? Are you seeing spread compressions at all?

Art Penn, Chairman and CEO

Yes. I mean, look, it has been a great time to be in the lending business, particularly if you can select good companies that can pay you back. So we have a really strong track record. In general, we have a good track record in the JV. Obviously, when you have assets that are primarily floating rate and there is spread compression, yields are going to decrease across the platform. Our credit facility, we also revised in PFLT, and we did that at a tighter spread. So while it may take a little while for the yields to fully adjust, if asset spreads are decreasing, liability spreads will also decrease, sometimes sooner, sometimes later.

Paul Johnson, Analyst

And then one more on the JV. What level or, if any, do you have loans within the JV? Does the structure allow this, and what percent, if any, is in the JV?

Art Penn, Chairman and CEO

Yes, it's very small. I don't have that information in hand here. We can definitely follow up, but our level of PIK is very low in the JV. Over the nearly four years, we've had one non-accrual in the JV to date, with Dynata Research. So it's been clean, but we can call you back later.

Operator, Operator

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

Melissa Wedel, Analyst

Art, you touched on my first point. I know that equity rotation has been a long-term pull, at least for part of the allocation there. You mentioned just now that it remains part of the strategy. Given the general sentiment around expecting a pickup in deal activity in the second half as rates come down, you didn't mention it earlier, but I'm wondering if there are any—if you feel like part of the portfolio is particularly well-positioned for that? Is there anything that we should be thinking about in terms of modeling and timing and rotating part of that?

Art Penn, Chairman and CEO

It's a great question. Last thing we want to do is overpromise and under-deliver, Melissa, right? Look, you're right; we believe deal activity will pick up. We believe interest rates will come down. We hope and believe that a portion of that equity portfolio will rotate. It's hard for us to provide an estimate or guidance on the amount or timing other than that it continues to be a goal of ours. Much of it isn't in our control; it particularly relates to equity co-investments, where we're riding alongside the private equity firm.

Melissa Wedel, Analyst

Yes. Okay. Understood. And then a follow-up question. I just wanted to revisit the dividend and the decision to take that up a little over a quarter or two ago. Given the earnings power of the portfolio right now, and considering the tailwind from the one-time dividend from PSLF this quarter, which meets the dividend level on a quarterly basis. How are you thinking about dividend coverage? And feeling just generally about the earnings power of the portfolio given the potential for a lower rate environment as we go forward, keeping in mind everything you just said about expanding the JV.

Art Penn, Chairman and CEO

Yes. Look, it's a great question. We're trying to balance the earnings power of the portfolio, the JV, the potential upsizing of the JV, and equity rotation. We do have about $1 a share of spillover, so we have to pay that out, and we want to pay it out judiciously over time in a careful fashion, being fairly fully levered at this point. We are balancing all these different competing interests in terms of paying out the spillover, looking at the earnings power of the company, and all the different elements of that. This really led to our decision to boost the dividend last quarter to $0.08 per month, largely due to all of these different elements, including the very large spillover.

Operator, Operator

And at this time, there are no further questions. I'll turn the call back to Art for any additional or closing remarks.

Art Penn, Chairman and CEO

Thank you, everybody, for participating today. We really appreciate your interest in the company. A reminder that next quarter is our 10-K. So the quarterly call will be a little bit later than our normal. We're targeting mid-November for the quarterly earnings release and the quarterly call. In the meantime, wishing everybody a terrific end to summer and fall. Speak to you next quarter.

Operator, Operator

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