PennantPark Floating Rate Capital Ltd

NYSE:PFLT

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, and welcome to the PennantPark Floating Rate Capital Second 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 Officer of PennantPark Floating Rate Capital. Mr. Penn, you may begin your conference.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital'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.

[Richard 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 a 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.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Thanks, Rick. We're going to spend a few minutes discussing 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 net investment income was $0.35 per share. Core NII was $0.34 per share, which excludes $0.01 per share for onetime interest income. GAAP NAV decreased slightly to $11.15 per share or 1.3%, which was due primarily to market-driven valuation adjustments on equity co-investments, partially offset by net investment income in excess of the dividend. With this backdrop of consistent earnings and a stable portfolio, the Board of Directors has improved an increase in the monthly distribution to $0.1025 per share, beginning with the July distribution. This represents a 2.5% increase in the monthly distribution and an 8% increase from a year ago.

During the quarter, we continue to originate attractive investment opportunities for both the PFLT portfolio as well as the JV portfolio. For the quarter, PFLT invested $85 million in new and existing portfolio companies at a weighted average yield of 12.2% and had sales and repayments of $63 million. For the investments in new portfolio companies, the weighted average debt to EBITDA was 4.0x, and the weighted average interest coverage was 2.1x and the weighted average loan to value was 55%.

We continue to believe that the current vintage of middle market directly originated loans should be excellent. Leverage is lower, spreads and upfront fees and OID are higher and covenants are tighter. 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 March 31, our weighted average yield to maturity was 11.8%, which is up from 11.3% last quarter and 7.5% last year.

As of March 31, the JV portfolio equaled $771 million. And together with our JV partner, we continue to execute on the plan to grow the JV portfolio to $1 billion of assets. Subsequent to quarter end, the JV closed its second CLO financing and the sixth CLO for the PennantPark platform. This new financing will allow the JV to further diversify and increase its balance sheet. We believe that the increase in scale and the JV's attractive ROE will enhance PFLT's earnings momentum.

We believe NII can continue to grow as we optimize the balance sheets of both PFLT and our JV. With leverage at PFLT at 1.17x debt-to-equity and target leverage of 1.4 to 1.6x, we plan on thoughtfully moving towards our target. 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.

In the face of a challenging economic environment and rising base rates, the credit quality of the portfolio continues to perform well. As of March 31, we had four nonaccruals out of 130 different names in PFLT. This represents 1.6% of the portfolio at cost and 0.4% at market value. Our investment in Walker Edison was returned to accrual status after the completion of a balance sheet restructuring, and our investments in Lucky Bucks and Output Services Group were placed on nonaccrual.

PFLT 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 PFLT share is estimated to be approximately $4 million.

As we look forward, we'd like being positioned for capital preservation as a senior secured first lien lender focused on the United States, where the floating rates on our loans can protect 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 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 and know the right questions to ask and have an excellent track record. They are business services, consumer, government services and defense, health care and software and technology. These sectors have also been resilient and tend to generate strong free cash flow. In our software vertical, we don't 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 fuel the growth and help 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 platform from inception through March 31, we've invested over $394 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.2x.

Because we are an important strategic lending partner, the process and package of terms we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive upfront fees and spreads and 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 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 the 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 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.

Our credit quality since inception over 10 years ago has been excellent. PFLT has invested $5.1 billion in 461 companies, and we've experienced only 18 nonaccruals. Since inception, PFLT's loss ratio is only 17 basis points annually. Our experienced and talented team and wide origination funnel was producing active deal flow. Our continued focus remains on capital preservation and being patient investors. Our mission and goal are steady, stable and protect the dividend stream, coupled with the preservation of capital. Everything we do is aligned to that goal. We seek to find investment opportunities in growing middle market companies that have high free cash flow conversion. We capture that free cash flow primarily in first lien senior secured 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 in more detail.

[Richard Allorto, Chief Financial Officer]

Thank you, Art. For the quarter ended March 31, net investment income was $0.35 per share and core net investment income was $0.34 per share. Core net investment income excludes $0.01 per share of onetime income related 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 expenses on debt were $9.8 million; base management and performance-based incentive fees were $7.1 million; general and administrative expenses were $850,000; and provision for taxes were $150,000. For the quarter ended March 31, net realized and unrealized change on investments including provision for taxes was a loss of $8.3 million or $0.17 per share. The unrealized appreciation on our credit facility and notes for the quarter was $1.2 million or $0.02 per share.

As of March 31, our GAAP NAV was $11.15, which is down 1.3% from $11.30 per share. Adjusted NAV, excluding the mark-to-market on our liabilities was $11.10 per share, down from $11.22 last quarter. As of March 31, our debt-to-equity ratio was 1.17x, 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 130 companies across 46 different industries; the weighted average yield on debt investments was 11.8% and 100% of the debt portfolio is floating rate; the portfolio was invested in 86% first lien senior secured debt, less than 1% in second lien debt, 4% in the equity of PSSL and 10% in other equity; debt to EBITDA on the portfolio is 4.8x, and interest coverage was 2.5x. The portfolio as a whole has a meaningful cushion with regard to interest coverage. On a sensitivity basis for overall interest coverage to decrease to 1.25x, base rates would need to go up 150 basis points and EBITDA would need to decrease by 35%.

Now let me turn the call back to Art.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Thanks, Rick.

[Operator]

And Art, we'll turn the call back to you. I apologize.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Great. 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'd like to open up the call to questions.

[Operator]

[Operator Instructions] We'll take our first question from Paul Johnson.

[Paul Johnson, KBW]

I guess you described a little bit of the just kind of general movements in the quarter, but were there any kind of, I guess, notable equity investments this quarter that contributed to the just sort of slight decline in NAV?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. It was -- thanks, Paul. The slight decline in NAV was several different minor movements in equity co-invest. We have an equity co-invest portfolio, which we said has generally been very positive for our vehicle here, the MOICs over time been 2.2x. This past quarter, it was a smattering of different names, By Light, GCOM, and PRA Events were three names that -- where the equity co-invest was lower than it was last quarter. PRA, we exited, and the exit fee on PRA was really the driver behind the onetime income. So we kind of got the onetime income, the NAV was kind of down a little bit on the mark. But no major culprits, just a wide variety of different small changes.

[Paul Johnson, KBW]

Yes. I guess in the quarter, as things progressed and quarter-to-date here, I'm just asking, are you guys starting to see any sort of notable uptick in amendment requests or potentially PIK conversions? Anything there?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. So there's nothing material on amendments or PIK. Certainly, it's a mixed economy. We're seeing a much more mixed economy than we saw coming out of COVID. Nothing material. Look, we have these quarterly tests, maintenance tests, which we talk about, which, in some sense, really give us a seat at the table early. And those could be good things to kind of get the right diligence done. They can mean fee income for us, additional equity potentially from the sponsor. Nothing meaningful, but certainly much more to date, but much more mixed economy certainly than we saw.

[Paul Johnson, KBW]

Got it. And then I'm just kind of curious, I'm trying to understand the financing arrangement and the JV. I'm curious, the CLO financing arrangements that you guys execute, are you able to kind of tell us like who's generally on the other side of those placements? Who's kind of the -- essentially the buyer of those securitizations? Are these banks in any way, any sort of regional banks, or are these more of a diverse set of investors or these -- at play?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. So these are AAA securities down to BBB securities, generally. The big buyers are insurance companies, the big buyers can be banks. It's a good asset for banks. The banks who have been winning deposits, it's a good asset because. It's a floating rate asset for them, and it's very secure.

I mean there's never really ever been a loss on AAAs. So it's a mixture of insurance companies and banks. And we typically hire a placement agent who goes and accesses the market. Now that we've had six CLOs, we have repeat investors who've gotten comfortable with us and our platform and how we invest. And we're getting the benefit of it becoming easier each time we do it because we're getting more well known in that marketplace.

[Paul Johnson, KBW]

That's interesting. And then lastly, just kind of maybe your general thoughts on what you guys, I guess, are seeing with the consumer, just in light of the slowing economy and it seems to be declining inflation, but obviously persistently kind of high inflation for some time now.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. It's -- I think the word mixed is what we've been using. The consumer is mixed. On one hand, they're going on trips and they're going on cruises and hotels and airlines. So the consumer is willing to pay for experiences and our exit on PRA Events is one end of the spectrum, and that's corporate events kind of rocketed back as companies in that case and individuals are happy to travel for experiences.

On the other hand, for goods, it's certainly been stickier. Walker Edison is another example on the other side of it where that's furniture, where consumers during COVID were buying a lot of furniture, and now it's much less so. So consumer is where there's some interesting action going on, both on the negative and the positive. So you really need to be attuned to what's going on and the movements within consumer demand. But clearly, people are paying for experiences, and they're paying a lot less for goods at this point.

[Operator]

We'll take our next question from Kevin Fultz from JMP Securities.

[Kevin Fultz, JMP Securities]

My first question relates to your outlook on portfolio yield. I'm assuming the Fed is nearing the end of its rate hiking cycle, do you see kind of nearing the peak in terms of portfolio yield? Or do you see incremental opportunity to pick up wider spreads that could drive portfolio yield higher longer term?

[Richard Allorto, Chief Financial Officer]

Yes. So trying to bet on what the Fed is going to do is just like being a weather man, you don't know. What we can tell from our portfolio though is inflation is not so easily stamped out. It's -- we had another read yesterday -- the economy had a read yesterday of 5% inflation. So this is not -- our PennantPark view is that this higher interest rate environment is going to last for a while. That said, we do get LIBOR floors or in this case, SOFR floors. I have to go change my nomenclature.

We get SOFR floors on all of our deals. And then we have two main -- we have two main mechanisms for growing NII and potentially the dividend here, PFLT. One is leverage. We're a little less optimized on leverage. We're 1.17x. Our target leverage is 1.4 to 1.6x. And then, of course, our JV, we just did that securitization financing and that JV is poised to grow to $950 million to $1 billion over the course of time, which should generate some healthy ROE for PFLT.

Today, the JV is $770 million. So we've got two levers, we think, to grow NII. Even if you take a stance that risk-free rates are coming down, SOFR is going to come down, we don't think so. But even if it is, we still feel very good about our income generation capacity, which helped drive our decision about the dividend increase.

[Kevin Fultz, JMP Securities]

Okay. I appreciate the insight there. And then just one more, I guess, in regards to portfolio positioning, are there any pockets or industries that you find particularly attractive right now? I'm just curious where you're seeing the rest of these return opportunities.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. So look, our 5 key sectors remain where we're focused. Health care, which is always needed, you got to be careful about reimbursement and cost, but health care, we've had a very good track record on. Government services and defense has always been a key sector for us in a world of geopolitical risk and uncertainty, that is a good sector, and the other sectors as well. Consumer, you got to be in the right area of consumer. Business services is a general catch-all, and software and tech remains good. We don't do ARR loans. We're classic EBITDA cash flow lenders. So those are the sectors, and those remaining sectors where we see the most opportunity.

[Operator]

And our next question comes from Mickey Schleien from Ladenburg.

[Mickey Schleien, Ladenburg Thalmann]

My question are just the following. We have this dynamic where the regional banks have their problems, obviously, and that may boost your opportunity in the lower middle market. But we also have large commercial banks constraining their lending and the BSL market is very tough for most lenders -- I mean, portfolio companies unless they are very high-quality. So that would imply you have opportunities up and down the middle market. But I've heard that spreads are actually pretty tight in the lower middle market. So I'd like to ask you, where do you see the best risk-adjusted returns today in terms of allocating your capital given the structure of PFLT?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Look, in the core middle market or some may call it the lower middle market, we are not seeing tight spreads. So you may be hearing that from some of the people who focus on the upper middle market. But we're seeing very wide spreads. We're seeing increased opportunity to do thorough due diligence, meaningful covenants, OID. So I don't know where you heard it from. It might be someone who's not in our market, but I can tell you, it's a good environment for us.

[Operator]

And our next question comes from Mark Hughes from Truist.

[Mark Hughes, Truist]

Art, could you comment on how the pipeline is looking, how 2Q may be shaping up in terms of investment activity? What you might see happening through the balance of the year to the extent anyone can see it?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. Look, things are starting to loosen up a little bit. There's starting to be more deal flow. No guarantees. It's never guaranteed from incoming inquiry to what we actually end up investing in since we are so selective. But it is starting to get busier. Our deal flow is starting to gain steam. Which of those deals end up on this side of June 30 or the other side of June 30? Your guess is as good as mine. Usually, it does take us at least a month, and usually 2 to 3 months to properly diligence, negotiate and execute a loan.

First quarter was -- is always seasonally slow. It was first calendar quarter we're talking. It was slower this year because of the turmoil in the market. And frankly, buyers and sellers need to figure out where the new equilibrium is, where they meet, given higher interest rates, given some economic uncertainty. So we're feeling like it's going to be a busier second half of the year. We'll see.

[Mark Hughes, Truist]

Very good. And then the CLO financing, any observations about this around the kind of the structure? You mentioned that you're getting generally more well known. Does that help in terms of the economics or is that more just the ability to transact? And if so, what's the tempo on that? When can you do the next one, so to speak?

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

Yes. So for now at PFLT, we are set at this point with securitizations, although we're always looking at the market and opportunities. So there may be other securitizations within the PFLT complex at some point. The PFLT complex means -- also means including the joint venture.

Look, I think getting well-known means more investors come to the table, it means an easier execution, and it could mean a tighter pricing. So the fact that our name in the -- in the middle market CLO market is now getting very well known. Our performance has been good. Our performance through COVID was really excellent. So we're pleased, and we thought the execution that we just got for the JV was attractive. And it's another form of financing that we will look to look to in the future as one of the many options that we have.

[Operator]

And at this time, we have no further questions. I'd like to turn the call back to our speakers for any closing remarks.

[Arthur Penn, Founder, Chairman & Chief Executive Officer]

I just want to thank everybody for their time today and your support, and we look forward to speaking to you next in early August when the June 30 numbers come out. So thank you very much. Have a good day, and have a great weekend.

[Operator]

Thank you. And ladies and gentlemen, that does conclude today's conference. We appreciate your participation, and have a wonderful day.