PennantPark Floating Rate Capital Ltd

NYSE:PFLT

Earnings Call Analysis

Company's Positive Performance and Strategy

The company achieved $0.32 per share in both GAAP and core net investment income for the quarter, with its NAV rising by 1.6% to $11.13 per share, thanks to beneficial valuations adjustments. No new non-accruals were reported, and the interest coverage ratio stood at 2.1x, despite base rate increases over the past year. Investments continued post-quarter, totaling $76 million in new and existing ventures. The firm targets growth in net investment income with a 1.5:1 debt to equity ratio, expanding its JV portfolio toward $1 billion in assets. They remain strategically positioned as a first-lien lender with floating rate loans to hedge against rising interest rates and inflation. Deal activity is perceived as picking up, seller multiples have normalized, and the market seems to have reached an interest rate equilibrium. Cautiously optimistic, they've navigated cyclical sectors well and seen only light repayments recently.

Stable Performance Amid Economic Uncertainty

In the face of rising interest rates and inflation, and amidst geopolitical and economic risks, the company has maintained a resilient performance. For the quarter ending September 30, the company reported a GAAP and core net investment income of $0.32 per share, demonstrating its ability to thrive even in a challenging base rate environment. Notably, the GAAP Net Asset Value (NAV) increased by 1.6% to $11.13 per share from $10.96 per share due to favorable valuation adjustments across debt and equity investments. This suggests a robust underlying portfolio, given the increase in NAV despite market volatilities.

Positive Investment Activity and Credit Quality

The firm has been actively investing in a diversified set of industries, injecting $94 million into 3 new and 31 existing portfolio companies, with a weighted average yield of 12.1%. Following quarter-end, an additional $76 million was deployed into new and existing investments. These actions underscore a strong and growing deal flow, which is anticipated to drive future growth in net investment income. Credit quality has remained stable, with no new nonaccruals reported, and a weighted average interest coverage ratio holding steady at 2.1x. Importantly, the core middle market continues to offer attractive investment opportunities with more favorable covenants, lower leverage, and higher yields compared to the upper middle market.

Sustained Focus on Capital Preservation

With a cautious approach to investment, the company has been adept at avoiding exposure to overly cyclical sectors such as construction or certain consumer brands, favoring instead investments tied to less volatile areas like infrastructure spending. This disciplined investment strategy has fostered capital preservation and establishes the firm's commitment to maintaining sturdy interest coverage—which currently averages 2x across the portfolio—ensuring it is well-positioned to handle economic headwinds.

Careful Monitoring and Covenant Protections

The company's thorough due diligence approach and insistence on meaningful covenants differentiate it from peers who might venture into more broadly syndicated and riskier upper middle market loans. The emphasis on first-lien senior secured loans, which constitute 85% of their investments, secures a strong position in potential repayment hierarchies, reinforcing the company's robust loss ratios and aligning with its long-term track record of excellence. Moreover, it has strategically avoided investments in sectors that could be more affected by current market trends, such as ARR loans in their software vertical.

Financial Prudence and Operational Efficiency

The firm's operating expenses, including interest and expenses on debt and management fees, are carefully managed. The detailed expense breakdown demonstrates the company's commitment to operational efficiency and investor transparency. Noteworthy is their prudent capital structure with a debt-to-equity ratio at a healthy 0.76x, and with the majority of their debt investments bearing a yield of 12.6%, reflecting a well-balanced approach to growth and risk management.

Closing Remarks and Forward Outlook

While repayments have been light quarter-to-date, suggesting a more cautious market, the management team expressed optimism in the earnings call and hinted at a stable forward outlook. They emphasized the value of their long-term investment approach and strategic capital deployment, with the next earnings release anticipated in early February. This forward-looking approach suggests a company that is both mindful of current market changes and committed to future growth.

Earnings Call Transcript 2023-Q4

[Operator]

Good morning, and welcome to the PennantPark Floating Rate Capital's Fourth 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, executive]

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Fourth 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, 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 middle market lending, how we fared in the quarter ended September 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 September 30, GAAP and core net investment income was $0.32 per share. GAAP NAV increased 1.6% to $11.13 per share from $10.96 per share. Adjusted NAV, excluding the mark-to-market adjustments on our liabilities increased to $11.13 per share or 1.2%. The increase in NAV for the quarter was due primarily to positive valuation adjustments on both debt and equity investments. With the debt portfolio that is 100% floating rate, we continue to benefit from the current base rate environment. As of September 30, our weighted average yield to maturity was 12.6%, which is up from 12.4% last quarter and 10% last year.

During the quarter, we continue to originate attractive investment opportunities and invested $94 million in 3 new and 31 existing portfolio companies at a weighted average yield of 12.1%. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.6x. The weighted average interest coverage was 2.3x and the weighted average loan to value was 36%.

We continue to believe that the current vintage of core middle market directly originated loans is excellent. Leverage is lower, spreads and upfront OID are higher and covenants are tighter than in the upper middle market. Despite reports of covenant erosion in the upper middle market, in the core middle market, we are still getting meaningful covenant protections. We are seeing an increase in deal flow compared to the first half of 2023 and have a growing pipeline of interesting and attractive investment opportunities.

Since quarter end, we have continued to be active. From September 30 through November 10, we've invested $76 million into new and existing investments and are continuing to see strong deal flow going into year-end. As of September 30, our debt-to-EBITDA ratio was 0.76:1, with a target ratio of 1.5:1, we believe that we are positioned to drive strong growth in net investment income going forward. Additional growth in NII can be driven by our joint venture. As of September 30, the JV portfolio totaled $786 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 $52 million into 5 new and 8 existing portfolio companies at a weighted average yield of 12%, including $37 million of assets purchased from PFLT. We believe that the increase in the scale of the JV's balance sheet will continue to drive attractive mid-teens returns on invested capital and enhance PFLT's earnings momentum. Credit quality of the portfolio is stable. We had no new nonaccruals in the quarter ended September 30. As of September 30, the portfolio's weighted average leverage ratio through our debt security was 5.1x and despite the steep increase in base rates over the last 12 months, the portfolio's weighted average interest coverage ratio at September 30 was 2.1x.

From an overall perspective, in this market environment of elevated inflation rising interest rates, geopolitical risk and a potentially weakening economy, we 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 us 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 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, 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. Approximately 12% of our portfolio is in government services and defense which is a sector with strong tailwinds in this geopolitical environment.

In our software vertical, we don't have any exposure to ARR loans. 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 upfront OID 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, unlike the erosion in the upper middle market, Virtually all of our originated first-lien loans have 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 broadly syndicated loan and upper middle market state that those companies are less risky. That might 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 and 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 $5.3 billion in 468 companies and we have experienced only 18 nonaccruals. Since inception, PFLT's loss ration is only 15 basis points annually. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall for our platform, from inception through September 30, we have invested over $410 million in equity co-investments and have generated an IRR of 26% at a multiple on invested capital of 2.2x.

Our experienced and talented team and wide origination funnel is 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 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 September 30, GAAP and core net investment income was $0.32 per share. Operating expenses for the quarter were as follows: interest and expenses on debt were $8.6 million. Base management and performance-based incentive fees were $7.4 million. General and administrative expenses were $1.1 million and provision for taxes were $150,000.

For the quarter ended September 30, net realized and unrealized change on investments, including provision for taxes was a gain of $9.5 million or $0.16 per share. The unrealized appreciation on our credit facility and notes for the quarter was $2.6 million or $0.04 per share. As of September 30, our GAAP NAV was $11.13, which is up 1.6% from $10.96 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $11.13 per share, up 1.2% from $11 per share last quarter.

As of September 30, our debt-to-equity ratio was 0.76x and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. We have sufficient liquidity in our revolving credit facility to repay the $76 million of unsecured notes maturing on December 15.

As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 131 companies across 45 different industries. The weighted average yield on our debt investments was 12.6% and approximately 100% of the debt portfolio is floating rate. We had 3 nonaccruals, which represent 1% of the portfolio at cost and 0% at fair market value. We did not put any new investments on nonaccrual during the quarter.

The portfolio is comprised of 85% first-lien senior secured debt, less than 1% in second lien debt, 5% in equity of PSSL and 10% in other equity. The debt to EBITDA on the portfolio is 5.1x, and interest coverage was 2.1x. The portfolio as a whole has a meaningful cushion with regard to interest coverage. On a sensitivity basis for the portfolio's overall interest coverage to decrease to 1x, base rates would need to go up 200 basis points and EBITDA would need to decrease by 40%. This analysis is based upon current run rate interest coverage, assuming a 5.5% base rate. 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 will take our first question from Ryan Lynch from KBW.

[Ryan Lynch, analyst]

First one I had was just on the level of repayments exits you guys have that's been pretty high the last couple of quarters. Can you just talk about, is there something going on that's really been in the marketplace has really been driving the higher level of repayments? Or is it just that a combination of kind of normal size repayments and your desire to kind of drop down some of those and exit some of those into the JV.

[Arthur Penn, executive]

Thanks, Ryan. Yes, certainly, some of those deals ended up in the JV for sure. And then I'd just say it's normal activity. When you pick solid credits, and they performed well and most of our portfolio is performing very well. You get paid off. Our origination flow has been a little lighter up until through 9/30. We've been busier since 9/30, I think we're going to be busier kind of coming into year-end and beyond. So deal flow has picked up. None of this was kind of intentional for us. We certainly can't manage repayments other than if they fit the JV. And then when we see attractive new deals come through, we clearly want to select those, and we've been seeing more of those in the recent weeks.

[Ryan Lynch, analyst]

Okay. So I'd love to just touch on that last point a little bit more. Can you just talk about the deal environment. Obviously, the deals that you guys are doing, you mentioned some pretty incredible stats with the leverage, interest coverage and loan-to-value on new loans as well as the spreads and the absolute yields are pretty high. I know there's certainly in the upper middle market, there's certainly hope that the deal activity is going to pick up as private equity and buyers and sellers start to get a little more clarity with interest rates and pricing. I'd love to just hear kind of your insights on what you're seeing in kind of the core middle market? And when do you think that, that would translate into a meaningful pickup in deal activity in your world?

[Arthur Penn, executive]

Yes. So we think that activity is picking up. We've seen it in lifetime, which is why we've added the recent development subsequent event disclosure to the press release. And our sense is kind of it's been -- sellers have been -- have needed some time to adjust to the new environment, the multiples that they could get selling their companies at the end of '21 are no longer generally available to them. So it's taken them a while to adjust to get their mind around it. Clearly, if you're a buyer of one of these companies, you have to absorb higher interest rates by definition.

So multiples have come down certainly from where they were in 2021, and that's taken some time to find its equilibrium. So that's been the biggest part of it. And I think mostly the other big part of it is there's a general sense that we're in kind of the interest rate zone that we're going to be in for a while, maybe it goes up a little bit, maybe it goes down a little bit. But in general, kind of people aren't going to be waking up kind of and seeing much higher interest rates or much lower interest rates, decisions can be made kind of whether the base rate of 5.5% or 5.75% or 5.25%, this is the zone people have accepted and they can, therefore, price that into the deals that they're trying to do.

[Operator]

And next, we'll go to Mickey Schleien from Ladenburg.

[Mickey Schleien, analyst]

Art, the portfolio has some exposure to what could be considered cyclical sectors like construction and consumer and auto and hotels and leisure, things like that. Can you describe how those credits are generally doing and the prospects for those credits going into next year as with the things we've read in the headlines with savings rates going down and credit cards being tapped out and things like that.

[Arthur Penn, executive]

Yes. No, we -- thank you, Mickey. We specifically try to avoid kind of cyclical names. So if something has the word construction next to it. It will be some kind of service business, typically something that's architectural or engineering services where the underlying market is less cyclical. So if we're in an architectural or engineering services business, it won't really be tied to homebuilding. It might be tied to infrastructure spending, which has been an area of growth or might be tied to a renovation, which goes on whether or not people have capital or not.

Consumer is something we're watching. Clearly, when we do consumer, we're very aware of the environment. So we specifically keep leverage lower on our consumer deals than we do on our average deals, and we typically try to find companies that have brands that have value and meaning in their marketplace. So Dr. Scholl's, that's an example. It's a big brand. It's a branded consumer company. Leverage is reasonable on it. People are aware of the brand.

So kind of RTIC, which is Yeti comparable. It's a lower cost version of Yeti. It's in our portfolio. When we did the deal, leverage was very low. And because it's a lower-cost version, it's actually doing pretty well in this kind of environment. So that's kind of how we think about consumer. That's how we kind of think about construction. I'm happy to dive deeper, if you like.

[Mickey Schleien, analyst]

Well, just in the auto sector, were any of those credits materially impacted by the strikes?

[Arthur Penn, executive]

You have names specifically on which names specifically, sometimes these...

[Mickey Schleien, analyst]

No, I just looked at the breakdown of the industries in the last Q, so I don't have...

[Arthur Penn, executive]

I mean if it's auto -- yes, if it's auto it would be something typically tied to auto aftermarket, which is kind of hopefully a steady state. We don't have any kind of exposure to OEM or exposure to stuff that was related to the strike, it will be products that are sold in the aftermarket. We have car wash companies. I don't know whether that's I forget whether that's auto or whether that's consumer or something else, but things like that.

[Mickey Schleien, analyst]

Okay. Just following up on Ryan's question about terms. In the upper middle market, as you know, we've started to see some spread compression, particularly for higher-quality borrowers. Have you seen that starting to trickle down into the middle market at all yet?

[Arthur Penn, executive]

Yes, I'd say kind of in our core market of $10 million to $50 million of EBITDA in the upper end of that, if a credit is perceived as really an excellent credit in a space that people love it may get a little competitive and spreads may tighten a little bit. Again, if it's an excellent credit, we're happy to be competitive. And then there's a piece of the world of -- as you get to the middle of the $10 million to $50 million are certainly the lower end where there's a lot less competition. And we haven't really seen much spread tightening there.

[Mickey Schleien, analyst]

Okay. My last question. I appreciate the recent developments language in the press release. Can you tell us anything about repayments for this quarter, apart from things that you might be transferring to the senior loan fund?

[Arthur Penn, executive]

The repayments have been light. Repayments have been light quarter-to-date.

[Operator]

And next, we're going to go to Maxwell Fritscher from Truist Securities.

[Maxwell Fritscher, analyst]

I'm calling in for Mark Hughes. So of the companies that have had amendments in fiscal '23, what percent would you judge has received additional capital support from the sponsor?

[Arthur Penn, executive]

I'm going to say certainly, the minority. I'm going to guess maybe about 1/3. Most of these are very minor amendments. In certain cases, the sponsors, we do ask them to put up additional capital and in all cases, so far, that additional capital has been forthcoming. And that's one of the nice things about where we are with the covenants we have, the information rights we have, and the loan to value that we have for a relatively small check sponsor relative to their initial investment in these companies, the sponsor can solve a problem. So certainly, the minority where there's a cash investment, we haven't seen any issues with the sponsors coming forward to date.

[Maxwell Fritscher, analyst]

Okay. And in regard to the interest coverage, have you seen a meaningful amount of portfolio companies, forgo, CapEx or hiring in order to keep a favorable ratio?

[Arthur Penn, executive]

Great question. We certainly sense that with less cushion in the system. I mean these are very thoughtful companies anyway, the vast majority owned by private equity firms. So they are always looking at their return on capital over the return on equity. So they're always focused on. And I think there's an even higher focus today. But on average, today, our companies are covering their interest 2x or something.

So it's certainly not the lush times of a year ago when it was kind of 3x interest coverage. Now you're down to 2x. So we still think there's a reasonable cushion. But there's certainly heightened awareness of the interest cost that they have to bear. In some ways, that's good. They're focused. They've got a lot of equity beneath us, and they want to make sure that their equity is safe.

[Operator]

I'd now like to turn the conference back over to our speakers for any closing remarks.

[Arthur Penn, executive]

Thanks, everybody, for being on the call today. We wish everybody a happy Thanksgiving, a Thanksgiving of gratitude and we look forward to speaking with you in early February at our next earnings release. Thank you very much.

[Operator]

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