Earnings Call Transcript - PNNT Q2 2023

Operator, Operator

Good afternoon and welcome to PennantPark Investment Corporation's Second Fiscal Quarter 2023 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 second fiscal quarter 2023 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 related 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 our target market environment, provide a brief summary of how we fared in the quarter ended March 31st, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, and open it up for Q&A. For the quarter ended March 31st, our net investment income was $0.26 per share. Core NII was $0.21 per share and excluded $0.05 of one-time interest and dividend income. GAAP NAV decreased slightly to $7.60 per share from $7.71 per share, or 1.4%. This decrease was driven largely by valuation adjustments on equity call investments, partially offset by net investment income in excess of the dividend. Our debt portfolio continues to benefit from rising base rates; as of March 31st, our weighted average yield to maturity was 12.1%, which is up from 11.9% last quarter and 8.4% last year. As a result of a stable debt portfolio and growing net investment income, the board of directors has approved another increase in the quarterly dividend to $0.20 per share. This is an 8% increase from the prior quarter and a 38% increase from a year ago. The dividend will be paid on July 3rd to shareholders of record as of June 15th. We are confident that with the continued strong credit performance, the increased dividend will be more than fully covered by net investment income. For the quarter ended March 31st, we invested $58 million in new and existing portfolio companies at a weighted average yield of 11.8% and had sales and repayments of $114 million. For the investment in new portfolio companies, the weighted average debt-to-EBITDA was 4.3 times. The weighted average interest coverage was two times and the weighted average loan-to-value was 49%. On March 31st, the JV portfolio equaled $748 million and, together with our JV partner, we continue to execute on the plan to grow the JV portfolio to $1 billion of assets. We believe that the increase in scale and the JV's attractive double-digit ROE will also enhance PNNT's earnings momentum. We continue to believe that the current vintage of middle market directly originated loans should be excellent; leverage is lower, spreads and upfront fees are higher, and covenants are tighter. The credit quality of the portfolio continues to perform well; as of March 31st, we had one non-accrual out of 135 different names at PNNT. This represents 1.1% of the portfolio cost and 0% at market value. Our investment in Walker Edison has returned to accrual status after completing a balance sheet restructuring. PNNT has an equity ownership in Dominion Voting, which, subsequent to quarter-end, settled their lawsuit with Fox News for $787 million. Dominion has communicated their intention to distribute the net settlement proceeds, and PNNT's share is estimated to be approximately $12 million. Now, let me turn to the current market environment. From an overall perspective in this market environment of inflation, rising interest rates, geopolitical risk, and a potentially weakening economy, we are well-positioned as a lender focused on capital preservation in the United States, where the floating interest rates on our loans can protect against rising interest rates and inflation. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities where we are an important strategic capital to our borrowers. 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 substantial domain expertise, know the right questions to ask, and have an excellent track record. They are business services, consumer, government services in defense, healthcare, and software technology. These sectors have also been recession-resilient and tend to generate strong free cash flow. In our software vertical, we do not have any exposure to ARR loans. In many cases, we are typically part of the first institutional capital into a company, and the loans that we provide are important strategic capital that fuels the growth. Of that $10 million to $20 million EBITDA company, we help it grow to $30 million, $40 million, $50 million of EBITDA or more. We typically participate in the upside by making an equity co-investment. High returns on these equity call investments have been excellent over time. Overall, for the platform from inception through March 31st, we've invested over $394 million in equity co-investments, generating an IRR of 26% and a multiple on invested capital of 2.2 times. Because we are an important strategic lending partner, the terms we receive are 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 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, virtually all of our originated personal loans have meaningful covenants, which help protect our capital. This is one reason why our default rate and performance during COVID were so strong, and why we believe we're well-positioned in this environment. The sector of the market for companies with $10 million to $50 million of EBITDA is the core middle market. The core middle market is below the threshold and does not compete with broadly syndicated loans or high yield markets. Many of our peers, who focus on the upper middle market, state that those 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 a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of the core middle market, more careful diligence, and tighter monitoring have been important parts of this differentiated performance. Since inception, PNNT has invested $7.4 billion with an average yield of 12%. This compares to a loss ratio of approximately 22 basis points annually. The 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 favorable. Our experienced and talented team and our wide origination funnel are producing active deal flow; a 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 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.

Rick Allorto, CFO

Thank you, Art. For the quarter ended March 31st, net investment income was $0.26 per share, and core net investment income was $0.21 per share. Core net investment income excludes approximately $0.05 per share of one-time income related primarily to the acceleration of OID amortization in connection with the early repayment of our loan to PRA. Operating expenses for the quarter were as follows: interest and credit facility expenses were $10.6 million; base management and incentive fees were $7.6 million; general and administrative expenses were $1.1 million; and provision for excise tax was $450,000. For the quarter ended March 31st, net realized and unrealized changes on investments and debt, including provision for taxes, was a loss of $11.8 million or $0.18 per share. The change in the fair value of our credit facility increased our GAAP NAV by $0.02 per share. As of March 31st, our NAV per share was $7.60, which is down 1.4% from $7.71 per share from the prior quarter. As of March 31st, our debt-to-equity ratio was 1.43 times, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of March 31st, our key portfolio statistics were as follows: the portfolio remains highly diversified, with 135 companies across 30 different industries; the weighted average yield on debt investments was 12.1%. The portfolio was invested in 57% first-lien secured debt, 10% in second-lien unsecured debt, 8% in subordinated notes to PSLF, 5% in other subordinated debt, 5% in PSLF equity, and 15% in preferred and common equity. 96% of the debt portfolio is floating rate with an average LIBOR floor of 1%. Debt-to-EBITDA on the portfolio is 4.6 times, and the LTM interest coverage ratio is 2.8 times. The portfolio, as a whole, has a meaningful cushion concerning interest coverage. On a sensitivity basis, for overall interest coverage to decrease to 1.25 times, base rates would need to rise by 150 basis points, and EBITDA would need to decrease by 35%. 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 my remarks. At this time, I would like to open up the call to questions.

Operator, Operator

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

Paul Johnson, Analyst

Hey, good afternoon, guys. Thanks for taking my question. I just want to make sure I understand this right. But the settlement that you guys announced in the press release last night that $12 million. So, are we looking at potentially like an $0.18 sort of one-time payment in a future quarter? At some point? Is that the correct number?

Rick Allorto, CFO

Yes, that's correct, Paul. That’ll come through as dividend income.

Paul Johnson, Analyst

Okay. Is that reflected in any way in the 331 mark, or is that mark pretty much the same?

Rick Allorto, CFO

No, it is not reflected in the 331 mark.

Paul Johnson, Analyst

Got it. Okay. I guess just kind of higher-level question, I guess in terms of like the opportunity set that you guys see today, in the past obviously, subordinated second-type opportunities, junior capital opportunities have been part of the strategy in PNNT for a long time. The strategy has been moving away from that in today’s world. I'm just curious, are you starting to see any attractive opportunities in that part of the market? Or at this point, there’s just not enough of a differentiation between, I guess maybe the first loan type of opportunities that you're seeing which are really stretched for junior capital?

Art Penn, Chairman and CEO

It's a great question. We have always been open to second-lien mezzanine financing, but the standards are high. The lesson we've learned is that timing is crucial; if your mezzanine financing is second-lien, and four years later things haven't gone well, that’s concerning. We remain active in the mezzanine and second-lien space, though some mezzanine financing today has a significant pick portion, which we are not in favor of due to much of the cash pay EBITDA being allocated towards first-lien payments. Therefore, we will be more selective in our mezzanine and second-lien ventures. However, our subordinated debt and equity investments through our PSLF joint venture, which primarily consists of first-lien collateral, provide attractive returns on invested capital backed by conservatively structured senior debt. This joint venture has about $750 million in assets, with our investment being around $150 million. We believe that continuing to grow this venture is a great way to achieve incremental yield in a safe manner.

Paul Johnson, Analyst

That makes sense and is helpful context regarding the opportunity set. I have one last question. Generally speaking about your equity co-investments, are those investments primarily reliant on some sort of M&A event from the sponsor, specifically a sale of the business or an exit from that business, to realize that equity co-investment? Or are there other methods that could be utilized over time for you to potentially cash out on some of those investments?

Art Penn, Chairman and CEO

Yeah, so, good question. We're going any heads up with a sponsor; we've had a very good long-term, 2.2 times MOIC over 17 years on that capital, so it's been very accretive. And just like the sponsor, there’s an M&A exit, there’s potential IPO exit. And then there's certainly dividends that can come out of that; the Dominion voting situation will result in a dividend coming at us out of a company because we’re an equity shareholder. So, we’re really aligning ourselves; I guess we could sell our equity to the sponsor, if we need or want liquidity. We haven't needed it and you generally don't like being on the opposite side of someone who may have slightly more information than you do. So, we haven't elected that route, but we could if we needed or wanted liquidity, sell the stakes back to the sponsor.

Paul Johnson, Analyst

That makes sense. And one last question, if I may, just going back real quick to the settlement payment in the future quarter. Do you guys have any thoughts on how you guys are going to treat that income? Special, maybe like a special one-time dividend, retain part of it, any thoughts on how you're going to treat it?

Art Penn, Chairman and CEO

Yeah, so, look, we always evaluate. I don't think we have any predisposition. We're building some nice spillover and that'll go into our dividend policy over the next year, year and a half. You saw a very nice bump in the dividend this quarter. We think it's sustainable based on ongoing NII. And we have this nice spillover that can potentially go into protecting that dividend over time.

Operator, Operator

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

Robert Dodd, Analyst

Hi, everyone. Congratulations on the quarter. I have a quick question about any visibility regarding potential buybacks. It would clearly be a significant advantage for shareholders once it happens. Do you think this could happen in the June quarter or later, for modeling purposes?

Art Penn, Chairman and CEO

We've been led to believe that will happen in this quarter that we're in right now, the quarter ended June 30th.

Robert Dodd, Analyst

Thank you. Regarding the equity, it is clearly decreasing as a part of the portfolio. If we exclude the current figures, we're still in the mid-teens, which aligns with the target we have for this process. To your point, while you could potentially liquidate it, it isn't something you necessarily have to do. How quickly do you expect it to approach your target of around ten, excluding the joint ventures?

Art Penn, Chairman and CEO

It's a great question. And yeah, look, it's tied to M&A deal flow; M&A deal flow has been slow, year-to-date. So, what normally when you make a private equity investment, people normally say it's a three-to-five-year life. And maybe things have been extended a year due to the market environment. So, look, I think we hope that over the next year or two, we're going to be able to get some reasonable exits and bring it down. I mean, back to the last question about Dominion, and that wasn't even included in the NAV for the March quarter because we did not know it was a potential event as of March 31st. You could have put that $12 million into the mix and said your equity percentage is higher than 15%. And that would have been right although this was a positive surprise out of the blue. So, I don't know yet. I can't really give you an answer. We're doing our best; we're not in control of much of this. But knowing that over time, we've had well in excess of a two times MOIC on this capital, you just got to wait until it happens.

Operator, Operator

We'll take our next question from Kyle Joseph with Jefferies.

Kyle Joseph, Analyst

Hey, good morning. Thanks for taking my questions. Just wanted to talk about the originations environment. And walk us through the cadence in the quarter. Obviously, deal flows right again; M&A right out there, but in terms of timing, are January and February fairly consistent? And did you see a big fall off in March post regional bank volatility and how the deal flow’s been kind of quarter-to-date?

Art Penn, Chairman and CEO

Yeah, so Q1, calendar Q1 was slow, as it normally is slow. And seasonally, June’s normally a slow quarter, made slower this year by the turmoil in the capital markets and the rising interest rates made even slower since the banking situation. The banking issues that we've had. So, what's going on is buyers and sellers, to a large extent, are still trying to figure out where they meet. Sellers still are hoping for value like it was a year or two ago, and buyers are baking in higher interest rates and potentially a softening economy. So, until there's equilibrio between buyers and sellers, there's not going to be a lot of deal flow. That statement, one statement, two is we are starting to see more deal flow. So, we are starting to see buyers and sellers get together and our deal flow is picking up. No guarantees as to what's going to close between now and June 30th, and what's going to close after June 30th, but it does feel like the second half of 2023 will certainly be busier than the first half.

Kyle Joseph, Analyst

Alright, got it. And then on the repayments, they were a little bit elevated in the quarter. Just wondering, is that RAM? Is some other one-time things in there? Obviously, it's never bad to get paid back, and never bad to get paid back when it really boosts your other income. But just wondering if that's a one-off or a trend?

Art Penn, Chairman and CEO

Look, RAM, by definition, is one-off and that happened up past quarter and PRA, APRA which is this corporate events company that we invested in, that was exited and that's where that one-time non-core positive fee came in from that exit. It was a company that had its corporate events company. So, by definition, in the middle of COVID, it was struggling. And as you can probably sense, people are getting out and about and traveling and corporate events have blossomed post-COVID. So, that company really paid us back well and early, and we had a very nice exit fee as part of the redo of the capital structure in the middle of COVID, which generated the one-time fee income. So really, those are the two primary drivers. I mean, are they one time or ongoing? We'll see; we certainly are going to have some companies that are tied to events and tied to travel. We have some trade show businesses, for instance, that were getting hurt during COVID. Those companies are now obviously doing very well. So, there might be more of that. And that is a piece of the portfolio; it's not an oversized piece but it's a piece of the portfolio, and those companies are doing well. Thanks, Kyle.

Kyle Joseph, Analyst

Got it. Thanks very much for answering my questions.

Operator, Operator

We'll take our next question from Mickey Schleien with Ladenburg.

Mickey Schleien, Analyst

Yes, good afternoon, everyone. Art, a lot of discussion about how folks are so excited about the current vintage of deals, and definitely agree. I'm curious whether you're being able to structure terms in these deals that will allow them to stay on the books as long as you would like, given how attractive they are, whether it's the tenor or the prepayment penalties that you're building in or anything else that you're able to do to ensure that, this will show up in the income statement a couple of years from now.

Art Penn, Chairman and CEO

Yeah, it's a good question. And the average investment in this last quarter debt-to-EBITDA 4.3 times very attractive; interest coverage two times and LTV about 50%. So, this is an attractive vintage, and I guess that's the blessing of the equity co-invest. That's our tail; when companies do well, we have that tail, and we participate in the company. We’ve had deals in the last six months where, even post-banking situation, the company could deleverage to two or three-times debt-to-EBITDA and commercial banks took us out. That's great. If we're in the equity, we are participating in the lower cost of capital, by definition, it means the company is a good free cash flow generator. And at some point, that equity value will be ascertained in some way, shape, or form. Dominion Voting paid off the debt, I don't know, two years ago. So, we still have this residual equity co-investment, which is paying off.

Mickey Schleien, Analyst

Thank you for that. Alright. Appreciate your time.

Art Penn, Chairman and CEO

Thank you.

Operator, Operator

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

Mark Hughes, Analyst

Yeah. Thank you. Good afternoon. Is there any potential variability in that Dominion payout? Or is that pretty well set? Are there any final wrangling on the numbers?

Art Penn, Chairman and CEO

That's why I estimate around $12 million; there are still legal fees and taxes that will be deducted, but it's largely in that range.

Mark Hughes, Analyst

Yeah. Art, what is your opinion on the credit environment here? We've been kind of tipping into recession for two years now. I'm just sort of curious how you think the economy is shaping up? You've got a unique view from where you sit, what's your stance?

Art Penn, Chairman and CEO

It's a mixed economy, certainly not what it was coming out of COVID, which everything was going gangbusters. The consumer is particularly mixed; on one hand, the consumer is happy to go take trips and go cruising and hop on planes and stay in hotels. On the other hand, when it comes to goods, it's been more cautious, buying furniture. Walker Edison, prior non-accrual was a furniture company. So, Walker Edison did great during COVID but is doing much softer now. So, it’s a bifurcated consumer; you got to be careful in the consumer space. So, it's much more mixed. I think obviously, when we underwrite credit here, we assume there's a recession; there may not be one. We may be able to skate by, which would be nice. But we assume there's a recession, and when we do our credit underwriting, we're putting that in the model to see how these companies would perform in a recessionary case. That's our assumption as prudent credit underwriters. Our house view is probably there might be a light recession, but that doesn't impact how we underwrite; we underwrite for a recession.

Mark Hughes, Analyst

Yeah, how bad would the recession have to be for it to be material to the portfolio?

Art Penn, Chairman and CEO

Hard to say. I mean, I think Rick and his numbers gave this sensitivity around EBITDA; would have to go down something like 35%. And at the same time, which is contradictory, base rates would have to go up 150 basis points, and you're down to one and a quarter times EBITDA to interest coverage. Obviously, if the economy is soft, the Fed's probably not going to raise rates. So, that's an interesting thing to think about, which is if the economy is soft, the Fed's probably reducing rates. Which will increase interest coverage because the yields will go down; we, of course, have floors, but the yields would go down. But I think you can do the work as much as I can; I think in an environment where yields are going down, investors may flock to yield vehicles like BDCs to take advantage of high yields. So, we don't know the scenarios.

Mark Hughes, Analyst

Thank you for that. Appreciate it.

Art Penn, Chairman and CEO

Thanks.

Operator, Operator

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

Melissa Wedel, Analyst

Good afternoon. Thanks for taking my questions. I wanted to touch on the dividend increase in the June quarter. I think it's like the sixth quarter that you've done an increase in the dividend. Just thinking ahead? Are you thinking about this dividend increase a little bit differently than the rest? Does this feel like maybe with where the forward curve is projecting right to go that this might be a good place to pause? Or will you keep looking to evaluate in the quarter?

Art Penn, Chairman and CEO

Yeah, I'm on the Fed with my answer, Melissa, which is we're going to let the facts and circumstances dictate how we go. I mean, the various facts and circumstances would be how's our JV expansion going? And is that going to continue to generate more ROE? How's our rotation of equity going? Obviously, equity rotation, and even things like Dominion, where we have fresh equity powder. How's that looking to be able to rotate that into yield? How's our spillover looking? We have substantial spillover that's on the positive side. And then on the potential issue side is where our defaults or non-accruals are, long-term rates, and our cost of financing. So, I think every quarter we do our best, we look at the facts and circumstances, and do our best. We're very pleased that we've taken a dividend up from $0.12 cents to $0.20 cents in a relatively short period of time, which does mimic the NII and earnings of the company. And we'll see where we go from here.

Melissa Wedel, Analyst

Alright, fair enough. Thinking about portfolio leverage, and where you guys are right now. Certainly, there's been rotation in the portfolios. But leverage is still fairly high. It doesn't sound like you're particularly pessimistic from a macro perspective. But how are you thinking about portfolio leverage? And where would you like to run that in an environment with the opportunities that you're seeing today?

Art Penn, Chairman and CEO

We are currently a bit over-leveraged, as we mentioned before, but we are targeting a leverage ratio of about one and a quarter times. We believe that with some repayments and equity rotations, we can easily achieve this goal. We are mindful of our accounts and our credit rating, as maintaining an attractive debt capital is crucial for us. Over time, we plan to gradually reduce our leverage to around one and a quarter while also working on optimizing our joint venture financing and the return on equity from those ventures, alongside our equity rotation efforts.

Melissa Wedel, Analyst

That's helpful. Thanks, Art.

Art Penn, Chairman and CEO

Thank you.

Operator, Operator

We'll take our next question from Casey Alexander with Compass Point.

Casey Alexander, Analyst

Hi, good afternoon. I have two questions. First of all, in relation to Dominion, I'd ask you to put my hat on for a second. And ask, would you model it in, and if you modeled it in, what quarter would you model it into?

Art Penn, Chairman and CEO

We have been informed that this pertains to the quarter that ended in June. While there are no guarantees, that's the information we've received, and I'm sharing it straightforwardly. It's important to note that this isn't something you can rely on to happen regularly. Sometimes, when your equity co-investment really performs well, it becomes difficult to model. It serves as a nice upside to balance the unavoidable downturns lenders experience occasionally. Regarding its impact on net interest income and dividends, we don't expect it to recur in the next quarter; we hope it will be included, but we will classify it as nonrecurring. However, it does contribute to spillover, and as we consider policies for long-term dividends, it will have an effect.

Casey Alexander, Analyst

Yeah. And it adds DNA. And I believe a previous question said $0.18 a share. I think when you net it out with versus incentive fees, it's more like $0.14 or $0.15 a share, I think is the real impact. My second question is, I realized it's a small position, but the restructured loan of Walker Edison, my understanding is that it's 100% pick; did you consider leaving it on non-accrual for the time being until such a point in time as the company is able to turn that into more of a cash pay instrument?

Art Penn, Chairman and CEO

It's a good question. The independent valuation firms are currently valuing that instrument at par. However, it's not particularly material for PNNT at this time. Our valuation firm has indicated that it’s a par instrument. If the company does not perform well in the next few quarters and the valuation decreases, we will reassess the situation. Fortunately, it's not a significant investment for us right now; it has underperformed. We are hopeful that the company will stabilize and that customers will start purchasing furniture from them, leading to steady EBITDA. Eventually, we hope our debt will be repaid and our equity will gain value, but it’s still early in the process.

Casey Alexander, Analyst

Alright. Well, I'm fully cognizant that in your actual, your original investment in Walker Edison, you guys took a very attractive gain. So, there are two sides to this story. So, alright, thanks for taking my questions.

Art Penn, Chairman and CEO

Thanks, Casey.

Operator, Operator

That will conclude our question-and-answer session. At this time, I'd like to turn the call back over to Mr. Penn for any additional or closing remarks.

Art Penn, Chairman and CEO

I want to thank everybody for being on the call today. We'll talk to you next time in early August for June 30th numbers. Thank you very much.

Operator, Operator

Thank you. That will conclude today's call. We appreciate your participation.