PennantPark Floating Rate Capital Ltd

NYSE:PFLT

Earnings Call Transcript 2024-Q4

[Operator]

Good morning, and welcome to PennantPark Floating Rate Capital's Fourth Fiscal Quarter 2024 Earnings Conference Call. Today's conference is being recorded. [Operator Instructions].

This is -- 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 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 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, core net investment income was $0.32 per share. As of September 30, our portfolio grew to $2 billion or 20% from the prior quarter. During the quarter, we continue to originate attractive investment opportunities and invested $446 million and 10 new and 50 existing portfolio companies at a weighted average yield of 11%.

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 3.4x, the weighted average interest coverage was 2.5x and the weighted average loan to value was 38%. Subsequent to quarter end, we remained active and invested over $330 million at a weighted average yield of 10.2%. Investment volume is increasing, we have a robust pipeline, and we expect the remainder of 2024 to be active.

During 2024, the market yield on first-lien term 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 directly originated 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 September 30, our debt-to-equity ratio was 1.35x to 1 with a target ratio of 1.5x to 1, we believe that we are 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.

During the quarter, PFLT closed the refinancing and upsize of $351 million 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 3.1x to 1, which creates plenty of liquidity for the company. Additionally, during the quarter, we closed on an amendment and extension of the truest revolving credit facility. The highlights of the amendment are an increase in total commitments to $636 million, a reduction in the rate to SOFR plus 225 which is 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 September 30, the JV portfolio totaled $913 million and the JV remained active during the quarter and invested $46 million in 5 new and 7 existing portfolio companies at a weighted average yield of 11.3%, including $45 million of assets purchased from PFLT.

GAAP and adjusted NAV decreased 0.3% to $11.31 per share from $11.34 per share. The decrease in NAV for the quarter was due primarily to the write-off of fees and expenses associated with the previously noted securitization refinancing and revolving facility amendment and extension. Credit quality of the portfolio has remained strong. We didn't add any new investments to nonaccrual status and nonaccruals represent only 0.4% of the portfolio at cost and 0.2% at market value. As of September 30, the portfolio's weighted average leverage ratio through our debt security was 4.1x, and the portfolio's weighted average interest coverage was 2.3x. We believe 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 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.

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 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, unlike 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 loans to the 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 13 years ago has been excellent. PFLT has invested $6.7 billion in over 500 companies, and we have experienced only 20 nonaccruals. [indiscernible] on invested capital is only 10 basis points annually. As a provider of strategic capital, [indiscernible] 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 $540 million in equity co-investments, 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 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 [indiscernible] senior securities 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]

[Audio Gap]. Thank you, Art. For the quarter ended June 30, GAAP and core net investment income was $0.24 per share and core net investment income was $0.32 per share. Core net investment income includes the add-back of $0.08 per share of onetime financing costs that were expensed during the quarter, net of the impact on incentive fees. Operating expenses for the quarter were as follows: interest and expense [indiscernible] on debt were $19.3 million. Base management and performance-based incentive fees were $7.8 million. General and administrative expenses were [indiscernible] taxes were $0.2 million.

For the quarter ended September 30, net realized and unrealized change on investments including provision for taxes was a gain of $3.4 million. As of September 30, our GAAP NAV was $11.31 which is down 0.3% from $11.34 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $11.31 per share, down 0.3% from $11.34 per share last quarter. As of September 30, our debt-to-equity ratio was 1.35x, and our capital structure is diversified across multiple funding sources including both secured and unsecured debt.

As of September 30, our key portfolio statistics were as follows. The portfolio remains highly diversified with [ 158 ] the companies across 46 different industries. The weighted average yield on our debt investments was 11.5%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 2.9% of total interest income during the quarter. We had 2 nonaccruals, which represent 0.4% of the portfolio at cost and 0.2% at market value. The portfolio is comprised of 88% first-lien senior secured debt, less than 1% in second lien debt, 3% in the equity of PSSL and 9% in other equity. Our debt to EBITDA on the portfolio is 4.1x and interest coverage was 2.3x.

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 Paul Johnson with KBW.

[Paul Johnson, analyst]

Congrats on the big deployment quarter. It's a very active year for the firm. But my only question, I guess, would be kind of what do you see in the current vintage that you currently find that's very attractive. And also, I know what are your kind of thoughts about the upcoming vintage in terms of kind of next year with the administration change over and a declining rate environment.

[Arthur Penn, executive]

Thanks, Paul, and good morning. Look, when you can originate loans that have an average debt-to-EBITDA of 3.4x average interest coverage of 2.5x., a loan-to-value of 38% and get kind of 550 over the risk-free rate on average. Our view is you're supposed to be doing that all day long. So as you know, we opt for safety and security over yield at PFLT. So we've had some yield compression over the last year. It seems to have plateaued for now. But I think these credit -- the credit quality that we get has been very, very high here in the core middle market where there's a lot less competition. All the big players have move it up and it just doesn't make sense for their business models to be lending to $10 million, $20 million, even $30 million EBITDA company. So we've been taking advantage of that opportunity. And -- we think it's a really good one.

I think in terms of the outlook, as you can tell, it's been busy from an M&A standpoint in the core middle market hopefully, that means we can rotate some of these equity positions. We've had a very good track record with these equity co-invests, as we've said, a 2x MOIC over 18 years now. So hopefully, we can get liquid on some of these rotate that capital into cash paying yield. And then with the activity, the question will be with the supply/demand curve in the core middle market can spread widen again because of the supply. That would be our hope. Even if they don't, we're very pleased with the vintage given the credit that I just outlined, but we would hope that perhaps with more supply spreads widen. In terms of the risk-free rate, that's way above our pay grade. Certainly, the market believes it's going to go down. The question will be how much? So did that answer your question, Paul?

[Paul Johnson, analyst]

Yes, yes. Good color there. But in this year, kind of talking about the current year and the current vintage, I mean, you say you're getting still meaningful covenants, but it's definitely been a tighter spread environment. So I would guess just ask you kind of where has the deterioration occurred in terms of the terms that you're getting. Has it just been a little bit of spread [indiscernible] resin or a little bit of pressure on pricing that you've seen? Or how has documentation held up? Are you getting the same covenants that you were getting versus last year or is it less fees or less equity co-investments, where has, if any, the deterioration or kind of the pressure, I would say, on terms occurred.

[Arthur Penn, executive]

Yes, that's a good question. Certainly, in the bad [indiscernible] days of rising interest rates and fear, and we were getting $575 or $600 or even $625 over. The covenant cushions were closer to 25%. That's where you negotiate your cushion to the to the base case today, they're 30% or 35%. So they're certainly wider than they were, but they're still there, and they're still protective.

I mean if you just want to go back to a dramatic example, you go back to COVID and the fact that there were quarter-to-quarterly maintenance test that these companies had to live up to as well as the fact that we were getting monthly financial statements along the way. really brought people to the table quickly to discuss and figure out how we were going to solve problems together. And we've seen a lot of the same phenomenon here -- well past COVID. It's really due to the loan to value that we're seeing because these sponsors have so much private equity capital beneath the debt, in the vast majority of the cases, if there's a problem with a covenant or any kind of liquidity problem, they're generally willing to put more equity in to solve that problem. And our nonaccrual rate has remained really low here, and we're very thankful for that, and we're protective of that. But one of the reasons is they've got so much capital beneath us that if it takes a little bit more capital to solve a problem, they're by and large willing to do that.

[Paul Johnson, analyst]

Thanks for that Art. And then for [indiscernible] I guess the decline in nonaccruals this quarter, could you just walk us through the driver of that? Was there any restructure written off in the quarter?

[Arthur Penn, executive]

Yes. So we had 3 nonaccruals last quarter, Dynata, Pragmatic and Walker Edison. Dynata restructured. Walker Edison and Pragmatic are still on nonaccrual. So same 2 out of 3.

[Paul Johnson, analyst]

Okay. And then last question, Rick. What -- could you tell us the impact just on a book value per share basis of the issuance from the ATM this quarter, if there was any?

[Richard Allorto, executive]

No impact on NAV. We're issuing under the ATM, either at or above NAV impact has been immaterial.

[Operator]

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

[Mark Hughes, analyst]

Art, anything with the dog in the offing and the potential pressure on government spending. Anything in your portfolio that you have your eyes on that could be impacted by that?

[Arthur Penn, executive]

It's a great question, Mark, and we all wish we knew what those will mean from an impact. As you know, defense, government services are -- have been a nice piece of this portfolio, steady and stable. Most of those businesses are service businesses where people walk into offices and do some form of cybersecurity technology, intelligence, it's not really building bombs and guns and bullets. So -- but it's been steady and stable. And maybe this cross currency or certainly the world from a geopolitical standpoint is a little messy right now. And of course, as taxpayers, we all want an efficient government, right? So we don't want our tax dollars to be used efficiently. So we'll see how it all plays through in terms of the government services and defense.

Health care is a big piece of what we do. We've had a very good health care track record, much better than our peers. We know some of our peers have stumbled in health care. I think it's just -- we keep our leverage pretty reasonable and low, like if you're if you're leveraging health care company 4x, 4.5x on a senior basis, you could get hurt, of course, but it's a lot less risky than the 6x or 7x that maybe some of our peers have done. So our health care track record has been good. We've selected the right companies in the right sectors. And we like all taxpayers, one an efficient health care system. So we'll see we're going to keep being conservative and -- if you keep leverage low, it can kind of solve for a lot of ills. Not to say there won't be impacts to be seen, but we're just going to stick to that.

[Mark Hughes, analyst]

Yes. Okay. I appreciate that. How about the -- your origination activity so far in the fourth quarter has been quite strong. How about repayments? How are you looking on a net basis?

[Arthur Penn, executive]

Yes. We are getting repayments. It happens. And that's good. When people pay us back, we say thank you. Sometimes, as you know, they don't. So we're getting repayments and that's due to a more active M&A environment, which, by and large, is good for us. The equity co-invest should churn a little bit more, turn those to cash. We'll get repayments. That's fine. We'll hopefully deploy capital sensibly and conservatively. So it's probably -- at least recently, I'll estimate, given the opportunity we've been probably making new investments $2 out to $1 getting repaid. That's just an off-the-cuff estimate. But that will ebb and flow.

[Mark Hughes, analyst]

And then the equity co-invest are you seeing in these new originations, kind of similar opportunity? Is that going to be a relatively stable part of the strategy both in terms of opportunity and then your appetite or your approach to those co-invest?

[Arthur Penn, executive]

Yes, it's a good question. I haven't now done this 18 years at PennantPark and before that elsewhere. That opportunity is always there. It's a question, do we take that opportunity. Sometimes we will graciously decline the opportunity depending on the situation, sometimes we'll work hard to invest more because we like the equity over a long period of time over many deals that's worked out, by and large, some big winners and there's some losers. But that's kind of the -- that's kind of the equity co-invest business. We've invested $540 million in the 18 years. And had a 26% IRR and a 2x MOIC, multiple invested capital. So it's generally worked. We certainly had some zeros in there. We certainly had some that have been a lot more than 2x.

[Operator]

We'll take our next question from Doug Harter with UBS.

[Douglas Harter, analyst]

Can you give us updated thoughts as to kind of how you're thinking about the dividend and maybe some of the puts and takes on earnings power in the coming year?

[Arthur Penn, executive]

Sure. It's a great question. We think about it all the time, as you might imagine. Let's -- because we're credit guys, we're going to hit the downside first. That's how we think what's the downside? Downside of the ports or interest rates, right? Interest rate is going to continue to come down. And then credit quality. We think credit quality will remain strong. Of course, there's never any guarantee. And the title of this vehicle is PennantPark Floating Rate Capital, which would imply that as interest rates rise and fall, this floating rate portfolio will take its cue from that to some extent. So certainly potentially lowering rates, credit quality and just highlighting that it's the title of this vehicle floating rate capital. So that's the downside.

On the upside, you have several different elements. We're not at target leverage yet. We're kind of at 1.3x, 1.35x, our target leverage is 1.5x. AB, equity co-investor rotation. You'll see some wind. As you go through our equity comes portfolio, you'll see some that are marked up substantially. Those are always right. Those are kind of leading indicators of companies that are going to be sold. We hope to get some decent equity reputation here in this more robust M&A environment. And then we have this JV opportunity, which gives us a very nice -- historically been a mid-teens return on capital.

So we're looking at that and saying, should we upsize the existing JV, should we do a new JV? JV has been very successful both for PFLT and PN entity. It's a nice way to take lower-risk senior assets leveraging up a little bit more than we would on the balance sheet of the BDC still safely though, are generating mid- to upper teens return on capital. And for the shareholder, we're managing more capital and our management company is not charging management fee on that. So those pure returns go into the bottom line of PFLT. So that's got some puts and takes. We'll see where we go. And hopefully, I answered your question.

[Operator]

With no additional questions in queue, I would like to turn the call back over to Mr. Penn for any additional or closing remarks.

[Arthur Penn, executive]

Just want to thank everybody for being on this call today, and the Thanksgiving with can let everyone know we are certainly grateful and thankful for the interest you show in PFLT and investing in the company. So wishing everybody a great holiday season, and we'll talk to you in February.

[Operator]

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