Earnings Call Transcript - PNNT Q2 2024

Operator, Operator

Good afternoon, and welcome to the PennantPark Investment Corporation's Second 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.

Arthur Penn, CEO

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

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. 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 disclosures 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.

Arthur Penn, CEO

Thanks, Rick. We're going to spend a few minutes commenting on the current market environment for private middle market credit, provide a summary of how we fared in the quarter ended March 31, 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 March 31, our GAAP and core net investment income was $0.22 per share. We are pleased to announce that the Board of Directors has approved an increase in the monthly dividend to $0.08 per share. The increase will be effective beginning with the June monthly dividend, which will be payable on July 1 to shareholders of record as of June 14. This represents a 14% increase in the monthly dividend. GAAP and adjusted NAV increased 0.5% to $7.69 per share from $7.65. As of March 31, our portfolio grew slightly to $1.2 billion or 2% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities and invested $188 million in 6 new and 43 existing portfolio companies at a weighted average yield of 11.7%. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 4.3x. The weighted average interest coverage was 2.1x, and the weighted average loan to value was 40%. We added 2 new investments to nonaccrual status and removed one investment. Nonaccruals represent 3.7% of the portfolio at cost and 3% at market value. For the quarter ended March 31, PIK income remained low at only 2.9% of total investment income, which we believe is among the lowest in the BDC sector. As of March 31, the portfolio's weighted average leverage ratio through our debt security was 4.4x, and the portfolio's weighted average interest coverage was 2.2x. These attractive credit statistics are a testament to our selectivity and conservative orientation, as well as our focus on the core middle market. On average, we have seen a 50 basis point tightening of first lien spreads over the last 6 months. However, 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 and upfront OID 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 are still getting meaningful covenant protections. At March 31, the JV portfolio equaled $924 million. And during the quarter, the JV invested $113 million, including $103 million of purchases from PNNT. With its current capital base, the JV portfolio can grow to $1.1 billion. Over the last 12 months, PNNT earned a 17.5% return on invested capital in the JV. We expect that with continued growth in the JV portfolio, the JV investment will enhance PNNT's earnings momentum in future quarters. 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 core middle market opportunities provides the company with attractive investments where we provide important strategic capital to our borrowers. We have a long-term track record of generating value by successfully financing growing middle market companies in 5 key sectors: business services, consumer, government services and defense, and software and technology. These sectors have also been recession resilient and tend to generate strong free cash flow from companies with $10 million to $150 million of EBITDA. Those companies are below the threshold, and we do not compete with the broadly syndicated loan or high-yield markets unlike our peers in the upper market. In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive is attractive. We have many weeks to 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 upfront OID, as well as an equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated first lien loans had meaningful covenants, which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. Many of our peers who are focused on the upper middle market state that those bigger companies are less risky. That is a perception that may make some intuitive sense, but the reality is different. According to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate or higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring have been an important part of this differentiated performance. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall, for our platform from inception through March 31, we've invested over $469 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1x. Since inception, nearly 17 years ago, PNNT has invested $8.1 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of approximately 19 basis points annually. This strong track record includes investments in primarily subordinated debt made prior to the global financial crisis, our legacy energy investments, and recently the pandemic. With regard to 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 that have high free cash flow conversion. We capture that free cash flow primarily through debt instruments and 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 March 31, GAAP and core net investment income was $0.22 per share. Operating expenses for the quarter were as follows: interest and credit facility expenses were $11.9 million, base management and incentive fees were $7.2 million, general and administrative expenses were $1.9 million, and provision for excise taxes were $0.8 million. For the quarter ended March 31, net realized and unrealized change on our investments and debt, including provision for taxes, was a gain of $1.8 million or $0.03 per share. As of March 31, our GAAP and adjusted NAV was $7.69 per share, which is up 0.5% from $7.65 per share in the prior quarter. As of March 31, our debt-to-equity ratio was 1.4x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of March 31, our key portfolio statistics were as follows: our portfolio remains highly diversified with 138 companies across 30 different industries, the weighted average yield on our debt investments was 12.5%, PIK income equaled only 2.9% of total investment income, we had 2 nonaccruals, which represent 3.7% of the portfolio at cost and 3% at market value. The portfolio is comprised of about 58% first lien secured debt, 5% second lien secured debt, 10% subordinated notes to PSLF, 4% other subordinated debt, 6% equity in PSLF, and 17% in other preferred and common equity. 97% of the debt portfolio is floating rate. Debt to EBITDA on the portfolio is 4.4x and interest coverage is 2.2x.

Arthur Penn, 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, I would like to open up the call to questions.

Operator, Operator

And we will go ahead and take our first question from Brian Mckenna with Citizens JMP.

Brian Mckenna, Analyst

All right. I just had one question on the dividend and coverage. So great to see the 14% increase in the monthly distribution, but that equates to $0.24 on a quarterly basis. And so probably looking at NII in the period that came in at $0.22. So I'm curious, why set the new dividend above the 1Q NII run rate? Does that imply you expect some healthy growth in core earnings moving forward? And ultimately, where do you think you'll shake down on dividend coverage over the next several quarters?

Arthur Penn, CEO

Thank you, Brian. That's a great question. First, it's important to highlight that we have considerable spillover, likely around $1 per share, which we will need to distribute a significant portion of anyway. Now, regarding our ongoing net investment income, we believe that based on the portfolio's performance and the continued growth of the joint venture, achieving $0.24 on a regular basis is feasible. These two factors are crucial in leading us to the decision to increase the dividend.

Operator, Operator

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

Robert Dodd, Analyst

Can you provide an update on Flock, particularly regarding the nonaccrual situation and your plans moving forward? At what point does it make sense for a lending business like that to be maintained as a portfolio of companies and operated as a specialty finance lease business?

Arthur Penn, CEO

Yes. The company's name is Flock Financial, and it specializes in financing and purchasing distressed consumer receivables. This is an area of focus for Robert and BDCs. We believe it's an intriguing time to have recapitalized the company by converting some debt to equity and injecting additional capital to support its growth, as we see it as a good opportunity to acquire assets and expand. We are committed to growing the company, having added strong management to the team. Once we stabilize the company, it could either be sold or retained, as it provides a very attractive yield. First, however, we need to ensure the company is heading in the right direction. We have restructured management, brought back some former managers, increased board oversight, and invested capital to enable deployment in this attractive market. This was the most significant nonaccrual situation. We also placed Walker Edison, a smaller position that has been marked down for several quarters, on nonaccrual as well.

Robert Dodd, Analyst

Understood. Regarding Flock, when do you think that capital could start generating income?

Arthur Penn, CEO

Certainly, we believe that within the next year is our goal. We expect to start generating yield again within this one-year timeframe. We have strengthened our management team and aim to stabilize our operations while also fostering growth.

Robert Dodd, Analyst

I appreciate that. Regarding the joint venture, the same types of assets are on the balance sheet, and you still want to grow that. It offers an extremely attractive return on capital through that structure. Can you provide an update on how large you would like that to be a year from now, considering the market environment?

Arthur Penn, CEO

As of March 31, it was $924 million. With the current capital, we can increase that to $1.1 billion. We are in discussions to potentially expand that joint venture and are open to pursuing additional joint ventures. This structure has worked well for PNNT and PFLT. When we consistently generate returns in the upper teens, it is favorable for us. It’s beneficial for shareholders as we manage more assets without increasing our base fees, providing attractive yields and returns on a cost-efficient basis. We are looking to possibly increase this joint venture, and in time, we may pursue other joint ventures as well.

Operator, Operator

And moving on to Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Art, just to follow up on the JV. You've already funded your commitments to the capital structure of the JV. Pantheon still has some unfunded commitment; this target of $1.1 billion, does that assume Pantheon finishes funding their commitment? And what's stopping that from occurring?

Arthur Penn, CEO

Yes. It's a good question and Rick may know off the top. I think we've all funded. If we haven't funded, we're going to be funding shortly. Right now, it's a 60/40 split between PNNT and Pantheon. So we're a quarter or max 2 quarters away from capping out to that $1.1 billion. And then the question is, is that where we stand, or do we want to upsize? Do we do another JV? So all options are on the table. Clearly, we like the structure. Pantheon's a terrific partner, by the way. And we're optimistic that we can do more over time.

Mickey Schleien, Analyst

So Art, as that JV grows, how are you going to manage the nonqualified asset bucket, which is already at 22%?

Arthur Penn, CEO

Yes. So we're constantly watching the 30% bucket. You may see that at quarter end; we've been purchasing T-bills on the balance sheet of PNNT, which are qualifying assets, which can help expand the 30% bucket.

Mickey Schleien, Analyst

Okay. I appreciate that. And the leverage of the JV is running around 2x. Is that where you want to see it? That's counting the notes to the members as debt. Is that about where you want it to be?

Arthur Penn, CEO

We're looking at a ratio of $2 of external debt for every $1 of junior capital, which includes the subordinated notes we and Pantheon own, as well as equity. We consider this as junior capital and leverage it at approximately 2:1.

Operator, Operator

And the next question will come from Mark Hughes with Truist.

Mark Hughes, Analyst

Yes. Thank you. I think you've addressed a lot of this. I was going to just ask about the sustainability of returns in the JV. You talked about high teens here recently. Is that something that's sustainable with that structure, just assuming kind of the reasonable returns in the underlying investments?

Arthur Penn, CEO

Yes, we believe it is. If rates decrease, yields will also decrease since these are floating rate assets. We finance the joint venture with floating rate liabilities, such as credit facilities or floating rate securitization financing. This creates a match, though when rates are high, we achieve a higher return on equity. Additionally, the focus is on credit performance. We are confident in maintaining strong credit performance. The senior portfolio we manage is well structured and conservatively underwritten. Currently, the senior loans we are issuing are at a debt-to-EBITDA ratio of 4.3x, with an interest coverage of 2.1x and a loan-to-value ratio of about 40%. This is the foundation of our joint venture, which we then leverage with floating rate credit facilities and securitization. While we are optimistic, if rates decline, it may be challenging to maintain those returns. We also need to ensure we continue to underwrite credit effectively and work to minimize nonaccruals.

Operator, Operator

And we'll take a question from Casey Alexander with Compass Point.

Casey Alexander, Analyst

I'm just curious, in the schedule of investments, Flock is listed as a sub-debt position. So I'm just kind of curious, who is ahead of you? And why would it be you guys who is making the decision to put management in?

Arthur Penn, CEO

Yes. So great question. So this is a specialty finance company. Regions Bank is the senior lender. We are a mezzanine lender, subordinated debt. As part of the restructuring, we're converting some of the mezzanine debt to equity, and we're doing some additional mezzanine debt, which is junior to Regions Bank. So this was a nonsponsored deal. So it was a founder that was running the company. And when the company needed extra liquidity, we're the ones who provided the liquidity. And between the liquidity provided and the conversion of debt to equity, we're in a majority equity position.

Casey Alexander, Analyst

Okay. Great. That's excellent color. Just as a matter of course, is there any Flock or Walker Edison that is also in the JV?

Arthur Penn, CEO

I don't believe there is any involvement of Walker Edison in the joint venture or Flock.

Casey Alexander, Analyst

Okay. Great. And lastly, I think you mentioned it, but I wished it. What was the company that came off nonaccrual in the quarter?

Arthur Penn, CEO

Yes. The company historically was called MailSouth. Its name changed to Mspark. It's been marked at zero for the last few quarters. It got sold, and we realized that zero, unfortunately. But it's now off the SOIBs; the company got sold.

Operator, Operator

And moving on to Kyle Joseph with Jefferies.

Kyle Joseph, Analyst

I apologize if I missed this, but just wanted to get a sense for competition and spreads. It looks like your yields for the quarter were fairly stable. Just give us a sense of what base rates versus spreads there, and it looks like the yields on new investments were a little lower. But just kind of been hearing mixed messages about banks either exiting or entering the space and just kind of what you're seeing in terms of competition.

Arthur Penn, CEO

Yes. It's a good question, Kyle, and we did not cover that earlier. Spreads have contracted about 50 basis points over the last 6 to 9 months in the core middle market, which is where we focus under $50 million of EBITDA, and that's just what the market has been. The M&A flow has been a little light. We've been busy, as you can tell; a lot of our business comes from both new platforms and existing companies, but spreads have tightened a bit to average 550 over the risk-free rate in our space, that along with what we think are attractive credit statistics like 4.3x debt-to-EBITDA, interest coverage of 2.1x, loan-to-value of 40%. So we still think those credit stats along with, call it, 550 over the risk-free rate average is very attractive, very attractive risk-reward. It’s unclear what happens between now and year-end. We are optimistic. We believe there will be a lot of activity between now and year-end, a lot of deal flow. And there may be a scenario where supply and demand widen spreads again; no guarantees, but you can certainly see that if a lot of supply hits the market, which we think is a possibility, that spreads may widen again. But either way, most importantly for us is we are credit-oriented. We're focused on credit, and we're okay taking a little lower yield if the credit is well underwritten.

Operator, Operator

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

Arthur Penn, CEO

Thanks, everybody, for participating. We really appreciate it. Next time we'll be doing the call in early August for the June 30 quarter. In the meantime, wishing everybody a terrific spring and summer. Speak soon.

Operator, Operator

That does conclude today's conference. We do thank you for your participation. Have an excellent day.