PennantPark Floating Rate Capital Ltd

NYSE:PFLT

Earnings Call Transcript 2023-Q1

[Operator]

Good morning and welcome to the PennantPark Floating Rate Capital's First Fiscal Quarter 2023 Earnings Conference Call. Today's conference is being recorded. [Operator Instructions]

It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive of PennantPark Floating Rate Capital. Mr. Penn, you may begin your conference.

[Art Penn, Chairman and Chief Executive Officer]

Thank you and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's first 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, Chief Financial Officer]

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 Floating Rate Capital 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 Chief Executive Officer]

Thanks, Rick. We're going to spend a few minutes discussing how we fared in the quarter ended December 31, how the portfolio is positioned for upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open it up for Q&A.

The combination of excellent credit quality and higher yields on our portfolio matched with a visible pathway to more optimized balance sheets at PFLT and the JV positions us for stable and growing NII over the coming quarters. For the quarter ended December 31, our net investment income was $0.30 per share. The credit quality of the portfolio remains solid. As we guided last quarter, we have placed one new loan on non-accrual.

As of December 31, we had only three non-accruals out of 126 different names in PFLT. This represents only 1.9% of the portfolio at cost and 0.6% at market value. Our credit statistics are among the most conservative in the industry with an average debt-to-EBITDA on our underlying portfolio of 4.7x. With a debt portfolio that is 100% floating rate, we are well positioned to continue to grow our net investment income as base rates rise.

For the quarter ended December 31, our weighted average yield to maturity was 11.3%, which is up from 10% last quarter and 7.5% last year. With this backdrop of consistent earnings and stable portfolio, the Board of Directors has approved an increase in the monthly distribution to $0.10 per share beginning with the March distribution. This represents a 5.3% increase in the monthly distribution.

We believe net investment income can continue to grow as we optimize the balance sheets of both PFLT and our JV. With PFLT leverage at 1.3x debt-to-equity and target leverage of 1.4x to 1.6x, we plan on thoughtfully moving towards our target. GAAP NAV decreased to $11.30 or 2.7%, which was due primarily to market related fair value adjustments to our equity portfolio and our new non-accrual, partially offset by an increase in GAAP NAV, due to fair value adjustments on our credit facility and notes and net investment income in excess of the dividend.

During the quarter, we continued to originate attractive investment opportunities for both the PFLT portfolio, as well as the JV portfolio. For the quarter, PFLT invested $66 million in new and existing portfolio companies at a weighted average yield of 11.2% and had sales and repayments of $63 million. For the new investments and new portfolio companies, the weighted average debt-to-EBITDA was 3.7x, the weighted average interest coverage was 2.3x, and the weighted average loan-to-value was 22%.

At quarter end, the JV portfolio was 751 million and we will continue to execute on our plan to grow the JV portfolio to $1 billion of assets. We believe that the increase in scale and the JV's attractive ROE will also enhance PFLT's earnings momentum. We believe that the current vintage of middle market directly originated loans should be excellent. Leverage is lower, spreads in upfront fees and OID are higher and covenants are tighter.

In January, we issued 4.25 million shares and raised $48 million, which provides the company with additional capital to invest in this excellent vintage in order to grow NII. From an overall perspective, in this market environment of inflation, rising interest rates, geopolitical risk, and a potentially weakening economy, we believe that we are well-positioned.

We like being positioned for capital preservation as a senior secured first lien lender focused on the United States where floating rates on our loans can protect us against rising 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, and defense, healthcare and software and technology. These sectors have also been resilient and tend to generate strong free cash flow. It is important to note that we do not have any crypto exposure in our software and technology investments.

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 fuel 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 our portfolio and overall for our platform from inception through December 31, we've invested over 375 million in equity co-invest and have generated an IRR of 27% and a multiple uninvested capital of 2.3x. 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 structured 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 received 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 our performance during COVID was so strong and why we believe we are well-positioned in this environment. This sector of the market, 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 a broadly syndicated loan or high yield markets.

Many of our peers who focus on the upper middle market state that those bigger companies are less risky. 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 and a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring has been an important part of this differentiated performance.

The borrowers in our investment portfolio are generally performing well. As we said earlier as of December 31, the weighted average debt-to-EBITDA in the portfolio was 4.7x and the average interest coverage ratio, the amount by which cash income exceeds the cash interest expense was 2.8x calculated upon LTM interest expense.

The interest expense coverage ratio when calculated using the annualized interest expense and the current LIBOR and SOFR base rates is 2.2x. This compares very favorably to the market average of 1.6x, which is [according to] [ph] Lincoln International.

Credit quality since inception over 10 years ago has been excellent. PFLT has invested $5.1 billion in 455 companies and we have experienced only 16 non-accruals. Since inception, PFLT's loss ratio was only 6 basis points annually. 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.

Our mission and goal, our steady stable and protected dividend stream, coupled with preservation of capital, everything we do is aligned in that goal. We seek to find investment opportunities and growing middle market companies that have high free cash flow conversion. We capture that free cash flow, primarily in first lien senior secured 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 in more detail.

[Rick Allorto, Chief Financial Officer]

Thank you, Art. For the quarter ended December 31, net investment income was $0.30 per share and operating expenses for the quarter were as follows: Interest and expenses on debt were 9.9 million, base management and performance based incentive fees were 6.4 million, general and administrative expenses were 850,000, and provision for taxes were 534,000.

For the quarter ended December 31, net realized and unrealized change on investments, including provision for taxes was a loss of 15.4 million or $0.34 per share. The unrealized appreciation on our credit facility and notes for the quarter was 2.1 million or $0.05 per share. As of December 31, our GAAP NAV was $11.30, which is down 2.7% from 11.62 per share.

Adjusted NAV, excluding the mark-to-market of our liabilities was 11.22 per share down from 11.59 last quarter. Our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. Our GAAP debt-to-equity ratio was 1.3x.

As of December 31, our key portfolio statistics were as follows: Our portfolio remains highly diversified with 126 companies across 44 different industries. The portfolio was invested in 87% first lien senior secured debt, including 17% in PSSL, less than 1% in second lien debt, and 13% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 11.3% and 100% of the portfolio is floating rate.

Now, let me turn the call back to Art.

[Art Penn, Chairman and Chief Executive Officer]

Thanks Rick. In closing, I'd like to thank our dedicated and talented team of professionals for their continued commitment to PFLT and its shareholders. Thank you all for your time today. And for your investment and confidence in us. That concludes our remarks.

At this time, I would like to open up the call to questions.

[Operator]

Gentlemen, thank you. [Operator Instructions] We'll go first to the line of Mickey Schleien at Ladenburg. Please go ahead. Your line is open.

[Mickey Schleien, Ladenburg]

Art, I wanted to understand your view on the outlook for credit. There are certain investments in the portfolio marked in the 80s or even below, which obviously indicate some distress, but meanwhile, we had a very strong January jobs number, and perhaps the possibility of a soft landing is even more real than we thought maybe even a quarter ago, but the consumer is retrenching. So, when we think about all of that, what do you see in terms of trends in terms of the portfolio's credit quality as this year progresses?

[Art Penn, Chairman and Chief Executive Officer]

Thanks, Mickey. It's a really good question. Let me just state that, when we underwrite new deals, today, we're assuming a soft economy out of the gate. That's our going-in assumption. That's how we need to underwrite. And usually, when you're – in our business when you're doing a 5-year to 7-year loan, you need to put a downside or a recession case in the model. At some point anyway, these odds are over a 5-year to 7-year period. You're going to hit a period of economic weakness.

When we're underwriting our new deals, we're assuming that there's a weak economy out of the gate. That said, it's not – you're right. It's not as clear given the data that we're all seeing that there really is that much of a soft economy, at least at this point. Certainly, the consumer area is one of most focus and how the consumer is doing. Walker Edison, our one new non-accrual is evidence of that. We've done extra scanning of our consumer portfolio recently in light of that.

Consumer, we always upfront put less leverage on out-of-the-gates than we did the rest of our portfolio. So, even though the rest of our portfolio at inception may have been underwritten at debt-to-EBITDA of 4.5x, our consumer names, we would typically underwrite even before this, kind of with a 3 handle on the 3x, 3.5x zone debt-to-EBITDA.

So, we were always upfront, kind of extra cautious on that. We've done an extra scan of the consumer companies. We've had external scrubbing, and we feel actually pretty good that the companies we've selected in that space have a real reason to be. People care about them. Their customers care about them. Their margins are sustainable. They've got real brands that have value. So, there's never any guarantee, but we feel fairly decent about that piece of the portfolio.

The rest of the portfolio, which is in our key industry is health care, government services, business services, technology, and software. Those names to date are performing pretty well, and we feel pretty good about that. Again, the comfort you get or we get is, we're conservative going in. We underwrite [below multiples] [ph]. That was the – that's been the key of PFLT from the get-go. We've specifically wanted a lower risk portfolio, knowing we would get lower yield as part of that. And now for 11 years, that seems to be working out.

[Mickey Schleien, Ladenburg]

I appreciate that in-depth explanation. That's really helpful. And just one follow-up question. On the right-hand side of the balance sheet, the balance of the principal on the 2023 notes is due at the end of the year. Just from the use of proceeds of the common equity offering, are you targeting some of those proceeds to go towards that or do you expect to use the credit facility or just proceeds from sales and repayments? How should we think about financing the maturity of those notes?

[Rick Allorto, Chief Financial Officer]

Mickey. So, the maturity is December of this year. So, right now, we're not specifically earmarking some of the equity proceeds for that refinancing. We do have the capability today to repay those bonds using the revolving credit facility. So, we're continuing to look at other refinancing options, knowing that we could use the revolving credit facility we have in place today to refinance that debt.

[Mickey Schleien, Ladenburg]

I understand. Those are all my questions this morning. I appreciate your time. Thank you.

[Operator]

Thank you. Our next question comes from Paul Johnson at KBW.

[Paul Johnson, KBW]

Hi, good morning guys. Thanks for taking my questions. Just given the overlap portfolio with the JV, just wondering if you have any thoughts around the nonaccrual, Walker Edison, if that should affect the ROE or the distribution rate from the joint venture at all?

[Art Penn, Chairman and Chief Executive Officer]

Yes. Thanks, Paul. No, the JV – it's a relatively small piece of the JV. It's a relatively small piece of PFLT. So, given the JV's high credit quality other than Walker Edison, as well as the anticipated growth, I think the JV was about 750 million of assets at quarter-end. We're targeting over time to get that to about 1 billion. So, we feel as though the NII there coming out of the ROE, coming out of that JV should continue to grow.

[Paul Johnson, KBW]

Okay. Thanks. And then just one investment, I had a question on, one particular credit research now was just marked down this quarter. I was curious if that was credit related, if there's any, sort of mark-to-market going on there and just, any sort of description of what exactly that investment company is?

[Art Penn, Chairman and Chief Executive Officer]

Yes. So research now is traded and actively traded in the BSL market. It's a company we've financed for a long-time. It's one of the predecessor companies called Survey Sampling we did a [private loan] [ph] for. So, we followed it over the years. We thought the credit was a solid credit. It did hit a little pocket of weakness recently. We don't feel as though at this point, there's accrual risk with research now.

They seem to have ample liquidity. There's a big slug second lien beneath it, a big chunk of equity beneath that. We feel our loan-to-value is in good shape and that even with – if they have soft results going forward, even with continued soft results, the first lien will be money good in any scenario.

[Paul Johnson, KBW]

Okay. Thank you. That’s helpful. Those are all the questions that I have today. Thank you.

[Operator]

Thank you. Our next question today comes from Kevin Fultz at JMP Securities.

[Kevin Fultz, JMP Securities]

Hi, good morning guys. And thank you for taking my questions. My first question is a platform level 1 on your deal selectivity rate and deal volume. Could you remind me where your historical average – sorry, what your historical average deal selectivity rate is and how that has trended recently? And then second, could you give us an idea of the total dollar value or number of deals you review on an annual basis?

[Art Penn, Chairman and Chief Executive Officer]

Yes. I mean, our [deal activity] [ph] rate is usually typically around 5% of what we track. There's a lot of deals which come in that are kind of what we call desk kills that don't even kind of get logged into our system. It's amazing once you have a publicly traded BDC or an [SBIC license] [ph], the amount of incoming e-mails that an organization can get. So, very high [deal activity] [ph].

The good news is our team knows really what fits our box. We have these five key vertical sectors where we have domain expertise. We can get to, kind of what's a PennantPark deal really quickly. What’s not a PennantPark deal, and then it's always about how you look at all the shades of gray and figure out whether you actually want to commit capital. So, usually, it's about 1,000 deals a year. We usually pick 50 or 60, and that's, kind of been the historical kind of hit ratio.

In terms of deal activity, certainly, it's slowed down, and that could be – at least this past quarter where it – today, the quarter ended March, it could be a couple of reasons for that: a, there's a typical seasonal slowdown first quarter. If anyone wanted to get a deal, typically, they'd like to get it done before December 31.

So, part of it that we are sure that there's some slowdown due to the new equilibrium in the market. Are people paying the multiples that they weren't paying a year ago or are they going to pay multiples a little bit less? Are sellers going to accept those multiples that are now less than they thought they could get a year ago?

So, like in any market, that shifting, the equilibrium – the buyers and sellers need to find their equilibrium. And we sense that, that's going on right now, as we speak. We're still active. We still get lots of things. We're still deploying capital. As we stated, it's a really good vintage. Leverage is low. The interest coverage is high, and loan-to-value is still – is excellent. I think the stat I drew out there was like 22% loan to value, 25% loan to value. It's really attractive.

So, we'll take it as it comes, deal by deal, and try to pick the right deals. I don't know if I answered your question, Kevin or anything else that you had in that question that needed an answer.

[Kevin Fultz, JMP Securities]

You hit all the points. Thank you. And then my follow-up is on how you're structuring new originations. Now that we're in a higher rate environment, are you negotiating higher interest rate [indiscernible] the new deals that you're doing?

[Art Penn, Chairman and Chief Executive Officer]

Well, the new deals that are coming in, just to give you a sense, on the senior side, a year ago, we might have been LIBOR or SOFR [575] [ph], you know 4.5x debt-to-EBITDA. And today, we're more like LIBOR, SOFR 650, maybe 700, maybe for the static quota for the actual deals we did was under 4x debt-to-EBITDA, but call it 4x debt-to-EBITDA. So, less leverage, more spread, more yield, obviously, because base rates are much higher.

So these new loans are 11%, 12% yielding loans. And the thing you got to look at is obviously interest coverage. The interest coverage statistic is because we're getting now 11%, 12% versus 7%, 8%, interest coverage credit stat is one that we all need to look at more carefully and make sure that the companies are in [good stead] [ph] as the types of companies we finance typically are more services businesses with low CapEx, working capital that's not that high. So, [2.4x] [ph] interest coverage, we still feel pretty strong about with our companies.

[Operator]

We'll take our next question from the line of Mark Hughes at Truist.

[Mark Hughes, Truist]

Thank you, good morning. Art, is there any notable trend in EBITDA among your portfolio companies generating growth, the pace of that growth over the last 12 months?

[Art Penn, Chairman and Chief Executive Officer]

Yes. Look, as I said – good question, Mark. As I said a moment ago, the only sector where we're seeing a little bit of weakness is consumer. The other sectors, we're still seeing revenue and EBITDA growth, call it, 5% to 10% year-over-year on average. So, consumer has been the one that's been flattish. Some of the consumer names are up, some are flat, and then some, like Walker Edison, are down. So, that's the only one where we're seeing a more mixed picture in that sector.

[Mark Hughes, Truist]

And then the mix, when you look at your new commitments, new investments in the quarter, how much of that was with existing borrowers versus new borrowers? And how has that trended lately?

[Art Penn, Chairman and Chief Executive Officer]

Yes. I mean, most of it has been new. Most of it's been new, but there are delayed draws that we have in the portfolio where the – that's part of the arrangement we have when we [indiscernible] with these companies that are these middle market growth companies where there's add-on acquisitions to do. They want to grow their EBITDA. We will, in many cases, do the initial term loan and then structure a delayed draw term loan, where there's an add-on to finance add-on acquisitions or growth. So, that's usually a substantial part of the pipeline as well.

[Mark Hughes, Truist]

Yes. And I know this probably depends on market circumstances, but the – what's your latest thought in terms of timing? You want to grow the JV to 1 billion, any thoughts on the pace you can do that?

[Art Penn, Chairman and Chief Executive Officer]

Yes. And you're right, it depends on deal activity. So, if [indiscernible] there are $15 million or $20 million, and we're at $750 million now, and we're trying to grow to 1 billion, that's kind of 8 to 12 deals. So, that's probably a 12-month methodical growing of that JV.

[Mark Hughes, Truist]

Great. Thank you very much.

[Operator]

And at this time, we have no further signals from our audience. Mr. Penn, I will turn it back to you, sir, for any additional or closing remarks.

[Art Penn, Chairman and Chief Executive Officer]

I just want to thank everybody for their participation this morning. And the next call we'll be doing is in early May. So, we look forward to speaking to you then, and we appreciate all your support.

[Operator]

This does conclude today's conference, and thank you for your participation. You may now disconnect.