PennantPark Floating Rate Capital Ltd

NYSE:PFLT

Earnings Call Analysis

Strong Portfolio Growth and Strategic Investments

PennantPark Floating Rate Capital reported strong results for the quarter ended June 30, with a 12% growth in portfolio to $1.7 billion and a net investment income of $0.31 per share. The company invested $321 million in 58 companies at an 11.5% yield and expects a robust second half of 2024. Despite tightening market spreads by 50-75 basis points, investments maintained low leverage and high covenant protections. The debt-to-equity ratio is 1.1:1 with substantial liquidity, and plans to upsize the JV portfolio to $1 billion further bolster future growth. The company emphasizes capital preservation and strategic equity co-investments, achieving a 26% IRR since inception.

Overview of Financial Performance

For the quarter ended June 30, PennantPark Floating Rate Capital (PFLT) reported a GAAP and core net investment income of $0.31 per share. Compared to the previous quarter, the portfolio grew by 12%, reaching a total of $1.7 billion. This growth is indicative of PFLT’s continued commitment to identify and pursue attractive investment opportunities within the core middle market.

Investment Activity and Strategy

During the quarter, PFLT invested $321 million in 11 new and 47 existing portfolio companies, achieving a weighted average yield of 11.5%. The firm is optimistic about the second half of 2024, suggesting increased activity in investments due to a robust pipeline. They expect their focus on the core middle market will yield fruitful returns, supported by a favorable vintage of loans characterized by lower leverage and stronger covenants.

Yield Trends and Market Conditions

Since the beginning of 2024, the market yield on first-lien loans has tightened by 50 to 75 basis points. However, the current yields of over 11% continue to make first-lien loans appealing, with the weighted average debt-to-EBITDA at 3.8x and interest coverage at 2.2x. The company's strategic focus allows it to secure meaningful covenant protections, a contrast to the erosion seen in the upper middle market.

Financial Ratios and Asset Quality

As of June 30, PFLT maintained a debt-to-equity ratio of 1.1:1, with a target ratio of 1.5:1. Its diversified capital structure supports liquidity and positions the company for net investment income (NII) growth. The portfolio has shown substantial credit quality, with 87% in first-lien secured debt. Nonaccruals are minimal, representing only 1.5% of the portfolio at cost, indicating sound asset performance.

Securitization and Credit Facilities Enhancements

PFLT closed a $351 million securitization transaction with a reduced weighted average spread of 1.89%, down from 2.39%, showcasing the benefits of a favorable market environment. Additionally, they increased commitments in the Truist revolving credit facility from $436 million to $611 million and plan further amendments, sustaining lower borrowing costs and extending the revolving period to 2027.

Future Outlook and Guidance

The company is poised for further growth entering the latter half of 2024, with expectations of stability in NII due to its joint venture portfolio, which currently totals $904 million with an aim to expand to approximately $1 billion in assets. PFLT's long-term strategy focuses on generating steady dividend streams while preserving capital, which has been supported by strong historical performance, evidenced by a negligible loss ratio on invested capital.

Earnings Call Transcript 2024-Q3

[Operator]

Good morning, and welcome to the PennantPark Floating Rate Capital's Third Fiscal Quarter 2024 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 now begin your conference.

[Arthur Penn, executive]

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Third Fiscal Quarter 2024 Earnings Conference Call. I'm joined today by Rick Allorto, our Chief Financial Officer.

Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

[Richard Allorto, executive]

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.

[Arthur Penn, executive]

Thanks, Rick. We're going to spend a few minutes discussing the current market environment for private middle market lending, how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials and then open it up for Q&A.

For the quarter ended June 30, GAAP and core net investment income was $0.31 per share. As of June 30, our portfolio grew to $1.7 billion, or 12% from the prior quarter.

During the quarter, we continue to originate attractive investment opportunities, invested $321 million and 11 new and 47 existing portfolio companies at a weighted average yield of 11.5%. We continue to see an attractive vintage in the core middle market. For investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.8x, the weighted average interest coverage was 2.2x and the weighted average loan-to-value was 47%.

Subsequent to quarter end, we remained active and invested over $115 million at a weighted average yield of 11.2%. Investment volume is increasing, and we have a robust pipeline and expect the second half of 2024 to be active.

During 2024, the market yield on first-lien loans has tightened 50 to 75 basis points. As the credit statistics just highlighted indicate, we continue to believe that the current vintage of core middle market loans is excellent. In the core middle market, leverage is lower, spreads are higher and covenants are tighter than in the upper middle market.

Despite covenant erosion in the upper middle market, in the core middle market, we are still getting meaningful covenant protections. As of June 30, our debt-to-equity ratio was 1.1:1, with a target ratio of 1.5:1, we believe that we are well positioned to drive additional growth in net investment income going forward. Securitization financing continues to be a good match for our lower risk first-lien assets. Subsequent to quarter end, PFLT closed on the refinancing and upside of a $351 million term loan, term debt securitization transaction with a weighted average spread of 1.89%, a 4-year reinvestment period and a 12-year final maturity.

The weighted average spread of 1.89% is a meaningful decrease of 50 basis points from the prior level of 2.39%. The main contributor to this decrease was a favorable market environment in which the AAA portion of the structure priced at an attractive weighted average spread of 1.75%. The ratio of external debt to PFLT's junior capital was 3.1:1, which creates plenty of liquidity for the company.

During the quarter, we added 2 new lenders to the truest revolving credit facility and upsized total commitments to $611 million from $436 million. In addition, this week, we expect to close on an amendment and extension of the truest revolving credit facility. The highlights of the amendment are an increase in total commitment to $636 million, a reduction in rate to SOFR plus 225, which is down plus -- down from SOFR plus 236 and an extension in the revolving period to 2027.

We expect continued stability in NII in part due to our investment in the joint venture. As of June 30, the JV portfolio totaled $904 million, and together with our JV partner, we continue to execute on the plan to grow the JV portfolio to approximately $1 billion of assets. During the quarter, the JV invested $85 million in 5 new and 11 existing portfolio companies at a weighted average yield of 11.6%, including $69 million of assets purchased from PFLT.

We believe that the increase in scale of the JV's balance sheet will continue to drive attractive mid-teens returns on invested capital and enhanced PFLT's earnings momentum. GAAP and adjusted NAV decreased 0.5% to $11.34 per share from $11.40 per share. The decrease in NAV for the quarter was due primarily to valuation adjustments on both debt and equity investments. Credit quality of the portfolio has remained strong. We added 2 new investments to the nonaccrual status. Nonaccruals represent only 1.5% of the portfolio cost and 1.1% at market value.

As of June 30, the portfolio's weighted average leverage ratio through our debt security was 4.1x and the portfolio's weighted average interest coverage ratio was 2.2x. We believe that this is one of the most conservatively structured portfolios in the direct lending industry and is a testament to our focus on the core middle market. We like being positioned for capital preservation as a senior secured first-lien lender focused on the United States. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities 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. These are sectors where we have substantial domain expertise, [ you have ] the right question to ask and have an excellent track record. There are business services, consumer, government services and defense, health care and software technology. These sectors have also been resilient and tend to generate strong free cash flow.

The core middle market, companies with $10 million to $50 million of EBITDA is below the threshold and does not compete with the broadly syndicated loan or high-yield markets unlike our peers in the upper middle 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 do our diligence with care. We thoughtfully structured transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads and equity coinvestment. Additionally, from a monitoring perspective, we received 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 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 most of the companies with higher EBITDA.

We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring had been an important part of this differentiated performance. Our credit quality since inception over 13 years ago has been excellent. PFLT has invested $6.3 billion and over 500 companies and we have experienced only 20 nonaccruals.

Since inception, PFLT's loss ratio on invested capital is only 10 basis points annually. As a provider of strategic capital, it fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall for our platform from inception through June 30, we've invested over $511 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2x.

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 are a steady, stable and protected 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, executive]

Thank you, Art. For the quarter ended June 30, GAAP and core net investment income was $0.31 per share. Operating expenses for the quarter were as follows: Interest and expenses on debt were $16.4 million, Base management and performance-based incentive fees were $9.2 million, General and administrative expenses were $1.5 million and provision for taxes were $0.2 million. For the quarter ended June 30, net realized and unrealized change on investments, including provision for taxes was a loss of $4.3 million.

As of June 30, our GAAP NAV was $11.34 per share, which is down 0.5% from $11.40 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $11.34 per share, down 0.5% from $11.40 per share last quarter. As of June 30, our debt-to-equity ratio was 1.1x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt.

As of June 30, our key portfolio statistics were as follows: Our portfolio remains highly diversified with 151 companies across 45 different industries. The weighted average yield on our debt investments was 12.1% and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 1.4% of total interest income for the quarter. We had 3 nonaccruals, which represented 1.5% of the portfolio at cost and 1.1% at market value.

The portfolio is comprised of 87% first-lien senior secured debt, less than 1% in second-lien and subordinated debt, 4% in equity of PSSL and 9% in other equity. The debt to EBITDA on the portfolio is 4.1x and interest coverage was 2.2x.

Now let me turn the call back to Art.

[Arthur Penn, executive]

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]

[Operator Instructions] We'll take our first question from Brian McKenna from Citizens JMP.

[Brian Mckenna, analyst]

It was another strong quarter of growth for the investment portfolio, and that's actually now increased 55% year-to-date. So what's the expectation around growth for the portfolio over the next couple of quarters? You still have capacity on the leverage side and then cash also remain somewhat elevated. So I'm just trying to think through the trajectory of the portfolio from here. And ultimately, if you're actually in a position to grow earnings into next year even with what's likely going to be lower base rates.

[Arthur Penn, executive]

Yes. Thank you. It's the right question. And I got to say we're busy. We're busy. We've been busy, obviously, over the last quarter too, may be somewhat differentiated than some of our peers who are in the upper middle market where it's been either slower or they have a severe competition going against the broadly syndicated loan market. Here in the core middle market, we're active. We're seeing a lot of deal flow. We're kind of doing their prototypical start with a platform that's a little smaller, but with add-on acquisitions, delayed-draw term loans, substantial equity from the sponsor and grow it over time.

So that's a lot of what we're doing. Hard to put a pin in it for you, Brian, in terms of actual capital deployed. We built a very nice war chest between the upsized Truist facility, a couple of hundred million dollar upsize, the upsized securitization and the ATM program. So really, really well positioned from liquidity and capital side to take advantage of the opportunity. And should the markets become choppier and that's certainly a possibility, having capital to be able to take advantage of that, should that happen. So feel like we're in a really good position liquidity-wise and capitalized to grow.

Certainly, in terms of NII per share as we lever up, that should fall to the bottom line. So we're trying to find the balance of keeping a lot of powder dry to take advantage of the vintage, to take advantage of the opportunity and also to leverage up and drive NII per share offer.

[Brian Mckenna, analyst]

Okay. Super helpful. And then just a follow-up on leverage specifically. So you've clearly leaned into ATM, the last several quarters and that's been a big driver of kind of leverage being quite a bit below that target range. So -- given where the stock is trading today, I'm assuming you'll shy away from raising equity capital, then leverage will start to move higher. But is there just a way to think about kind of the time line around getting back to that 1.5x leverage target?

[Arthur Penn, executive]

Yes, it's a good question. Look, with the stock where it is today relative to NAV, we're not going to be -- that would be dilutive. We would not issue shares. We would -- that we would not do that. We're very pleased that we did the last round of ATM, we raised it around $11.40, so feel good about that. Today, it's the time to deploy that capital and the capital we've built on the credit facility side, on the CLO side. So I think right now, we kind of timed it propitiously or whatever, and now it's the time to kind of deploy and use the capital to take advantage of the opportunity.

[Brian Mckenna, analyst]

Okay. Great. And then, Art, just one more bigger picture question for you. You've clearly operated the business through a number of different cycles and operating environments. And the macro today remains very fluid. And there's quite a bit of uncertainty just around kind of the broader economic outlook into 2025. So I'm curious, what are your broader thoughts on where we are in the cycle, what this evolving macro means for your business? And then are you leaning in on any of your past experiences to make sure that PFLT remains well positioned to deliver strong results for all stakeholders.

[Arthur Penn, executive]

Yes. Thank you. Look, we have been in business -- we're going into our 18th year. So we've lived through the global financial crisis, an industrial downturn in the middle of last decade, the pandemic -- and most of it still comes down to the micro versus the macro. The micro being select excellent companies, keep the leverage low and sensible structure, good packages, including meaningful covenants. And if you do that, while maintaining liquidity at the vehicle level, making sure you have dry powder to defend and to play offense, the rest of it usually takes care of itself. So that's kind of lessons from many years in the business.

Hard to say whether we're going into a recession or not. Any good credit underwriter always underwrites deals with a recession case in the underwriting package. Let's assume there's a recession, what happens or what are the levers the company has to pull, how much costs are variable, how much are fixed, can CapEx be managed, working capital be managed? So PFLT has about 150 names. If you go back to the credit members and all of them, we had downside cases. We had recession cases in all of them. And so -- of course, you always can get surprised. But generally, we have pretty solid packages, and you're seeing it in the portfolio.

Nonaccruals are very low. When we do have a nonaccrual, they're usually idiosyncratic and even our consumer names, and we have some consumer in the portfolio are generally performing just fine right now.

[Operator]

We will take our next question from Doug Harter from UBS.

[Douglas Harter, analyst]

Can you talk a little bit about the competition you're seeing on new loans, both in terms of spreads and covenant packages.

[Arthur Penn, executive]

Sure, Doug. Thank you. So spreads, as we said in the prepared remarks, are down over the course of the year -- over the course of 2024. We're now in August, 50 to -- in some cases, 75 basis points. That's driven by some of our peers. That's driven by what's been a stable sanguine environment that's been driven by high base rates. When you're still getting 11-plus percent on a first-lien on an absolute basis, that's still attractive for investors, even though the spread obviously is tightened than it was 9 months ago. So we have seen spread tightening.

That said, as we kind of reviewed the statistics in the prepared remarks, we are getting really nice packages. So we still think it's an attractive vintage. Average debt to EBITDA on the new loans was 3.8x. And average interest coverage 2.2x even in these elevated rates and the weighted average loan to value of 47%. And we are getting meaningful covenant protection. That's one thing you get in the core middle market that you may not get in the upper middle market is covenants that are meaningful, that are quarterly maintenance tests that the companies have to meet. And if they don't meet them, there's a conversation.

Additionally, the overall structures are much stronger structures. So there's been a lot of press on some of the names in the upper middle market and some of the -- I'll call it, [ shenanigans ] that went on with moving intellectual property around and getting assets away from the lenders, et cetera. None of that happens in the core middle market, it's just not allowed, because the upper middle market went covenant light and had to compete with a broadly syndicated space. That was just a market they had to absorb in our market, these are very strong structure. So we feel very good about the vintage to date, even though the spreads are down. We feel very good about the credits and the yields and nonaccruals continue to be light, and the portfolio is generally performing very well.

[Operator]

We will now move to Maxwell Fritscher from Truist Securities.

[Maxwell Fritscher, analyst]

[ I am on for ] Mark Hughes. Kind of going off the competition question. You mentioned all the benefits of operating in the core middle market. Are you seeing any of those competitors from the upper middle market or the middle market come downstream a little bit to tap these better loan values and better covenants?

[Arthur Penn, executive]

It's a great question. We have not seen a lot of evidence of the big players moving down into the core. Now it depends how you define core. We define core as $10 million to $50 million of EBITDA. Occasionally, you'll see some of the big guys come down to a $40 million or $50 million EBITDA company. They can deploy a couple of hundred million in one check, but that's occasional. And many of our deals in are prototypical situation is. It's a company that's doing $10 million to $20 million, and it's a fragmented industry. There's a game plan. There's identified acquisitions for growth, and the goal is to take that $10 million to $20 million EBITDA company growth to 30, 40, 50 and above. So we'll be that lender that's strategic to the borrower.

We will provide delayed draw term loan and a pathway to get that company larger. And so if we're doing that, it's less about the last few basis points. It's much more about are we aligned in terms of the game plan for growing the company. And certainly, in some of those companies, since we're growing those companies, the equity story is actually very attractive, which is why we like, in many cases, doing the equity co-investment, and putting some of our capital side-by-side with the sponsor, so that we can participate in some of the upside that we're helping to generate on the debt side. And those the equity co-invest over 17 years, over [ $500 million ] deployed in our various vehicles have had a 2x multiple on invested capital in the 26% IRR. So that's a nice bonus of our model.

[Maxwell Fritscher, analyst]

Yes. And then with a little bit more visibility and clarity into the future rate trajectory and Fed actions. Have you seen any portfolio companies kind of resume normalized CapEx spending add-on acquisitions, assuming that they previously paused these investments?

[Arthur Penn, executive]

It's case by case. I don't know that I can give you one that kind of sticks out where someone's proactively leaning in ahead, we just don't -- I think most of our companies just have long-term game plans to kind of stick to them and have pulled back if needed, there's unfortunately nothing that comes to my mind that kind of sticks out as someone who is proactively leaning into a situation where they're kind of running ahead of it.

[Operator]

I will now turn the call back to Art Penn for any additional or closing remarks.

[Arthur Penn, executive]

I want to thank everybody for being on the call today, and we have Rick Allorto, our Chief Financial Officer, and our entire team. Thank you for your interest. Looking forward to speaking to you in mid-November, reminder that the 9/30 quarter is our 10-K. So our earnings release and call will be out a little bit later than our typical quarterly timing, but we look forward to speaking to you then. Thank you for your interest, and have a great rest of the summer.

[Operator]

This concludes today's call. Thank you for your participation. You may now disconnect.