PennantPark Floating Rate Capital Ltd. (NASDAQ:PFLT) Q4 2022 Earnings Call Transcript

PennantPark Floating Rate Capital Ltd. (NASDAQ:PFLT) Q4 2022 Earnings Call Transcript November 17, 2022

PennantPark Floating Rate Capital Ltd. reports earnings inline with expectations. Reported EPS is $0.29 EPS, expectations were $0.29.

Operator: Good morning and welcome to the PennantPark Floating Rate Capital’s Fourth Fiscal Quarter 2022 Earnings Conference Call. Today’s conference is being recorded. It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive of PennantPark Floating Rate Capital. Mr. Penn, you may begin your conference.

Art Penn: Thank you and good morning, everyone. I’d like to welcome you to PennantPark Floating Rate Capital’s fourth fiscal quarter 2022 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 includes a discussion about forward-looking statements.

Richard Allorto: 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.

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Art Penn: Thanks, Rick. We’re going to spend a few minutes discussing how we fared in the quarter ended September 30, how the portfolio is positioned for upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open it up for Q&A. For the quarter ended September 30, our core net investment income was $0.30 per share which includes $0.01 of other income and excludes $0.01 per share of onetime upfront financing costs from the $66 million increase in our revolving credit facility. The credit quality of the portfolio remains solid and we did not have any new nonaccrual investments. As of September 30, we had only 2 nonaccruals out of 125 different names in PFLT. This represents only 0.9% of the portfolio at cost and 0.01% at market value.

Our credit statistics remain among the most conservative in the industry with an average debt-to-EBITDA on our underlying portfolio of 4.7x and interest coverage of 3x. Our NAV decreased from the prior quarter, due primarily to unrealized mark-to-market adjustments tied to the overall market and not due to fundamental credit factors. GAAP NAV decreased by 4.8%, of which 3.3% was due to market-related fair value adjustments. The remainder of the decrease in GAAP NAV was primarily due to fair value adjustments on our credit facility and notes. With the debt portfolio, that’s 100% floating rate, we are well positioned to substantially grow our net investment income as base rates rise. The weighted average yield to maturity on our portfolio increased to 10% from 8.5% last quarter.

Holding everything else constant in the portfolio, every 100 basis point increase in base rates translates into about $0.03 per quarter of NII. We believe that this late 2022 and 2023 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. Our capital which we believe is always value added, is adding even more value in this environment. During the quarter, we continued to originate attractive investment opportunities for both of the PFLT portfolio as well as the JV portfolio. At quarter end, the JV portfolio was $757 million and we will continue to execute on our plan to grow the JV portfolio to $1 billion of assets. We believe that the increase in scale and the JV’s attractive ROE will enhance PFLT’s earnings momentum.

From an overall perspective in this market environment of inflation, rising interest rates, geopolitical risk and potentially weakening economy, we believe we are well positioned. We like being positioned for capital preservation as a senior secured first lien lender focused on the United States, where floating rates on our loans can protect against rising inflation. We continue to believe that our focus on core middle market provides the company with attractive investment opportunities where we are an important strategic capital to our borrowers. In times of market volatility, our direct lending strategy focuses on creating value from the dislocation in the markets. Specifically, we’ve been active buying first lien loans in the secondary market at discounts in companies where we believe we have differentiated institutional knowledge.

It could be a company that we used to finance and a sector where we have domain expertise or direct relationship with the management team or a financial sponsor. We have been buying loans where we think we can generate double-digit or low teens IRRs as the loans return to par in 3 years. We employed a similar strategy during the global financial crisis and generated excellent returns. We have a long-term track record of generating value by successfully financing high-growth 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 been resilient and tend to generate strong free cash flow. It’s important to note that we do not have any crypto exposure and are software technology investments. In many cases, we’re typically part of the first institutional capital into a company where a founder, entrepreneur or family is selling their company to a middle market private equity firm. In these situations, there’s typically a defined game plan in place with substantial equity support from the private equity firm to significantly grow the company through add-on acquisitions or organic growth. The loans that we provide are an 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 September 30, our $355 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.5x. With the current volatility in the broadly syndicated loan market, we have seen more private equity sponsors tap to private credit markets. We are selectively looking at these new opportunities and believe the vintage for these loans will yield compelling returns. Because we are an important strategic lending partner, the process and packaging terms we receive is attractive. We have many weeks to do our diligence with care.

We thoughtfully structured transactions with sensible credit stats, 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 a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring have been an important part of this differentiated performance. The borrowers in our investment portfolio are generally performing well. We said earlier — as we said earlier that as of September 30, the weighted average debt-to-EBITDA on the portfolio was 4.7x and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3x.

This provides significant cushion to support stable investment income even as interest rates rise. Based on this substantial cushion, even with the 200 basis point rise in base rates and a flat EBITDA, our portfolio companies will cover their interest 2.1x on average. These stats are among the most conservative in the direct lending industry. Our credit quality since inception over 10 years ago has been excellent. PFLT has invested $5 billion in 451 companies and we’ve experienced only 15 nonaccruals. Since inception, PFLT’s loss ratio is only 6 basis points annually. Our experienced and talented team and our wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors.

Our mission and goal 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: Thank you, Art. For the quarter ended September 30, net investment income was $0.29 per share, including $0.01 per share of other income. Operating expenses for the quarter were as follows: management fees and performance-based incentive fees were $6.2 million, interest and credit facility expenses were $9 million, general and administrative expenses were $800,000 and provision for taxes were $100,000. Core net investment income was $0.30 per share which excludes $0.01 per share of onetime upfront financing costs from the $66 million increase in our revolving credit facility. For the quarter ended September 30, net realized and unrealized change on investments, including provision for taxes, was a loss of $19.6 million or $0.45 per share.

The unrealized appreciation on our credit facility and notes for the quarter was $6.2 million or $0.14 per share. As of September 30, our GAAP NAV was $11.62 which is down 4.8% from $12.21 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.59 per share, down from $12.02 last quarter. Our GAAP debt-to-equity ratio, net of cash, was 1.19x for the quarter. Our capital structure is diversified across multiple funding sources and we do not have any near-term maturities. During the quarter ended September 30, we increased our revolving credit facility by $66 million at the existing spread. As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 125 companies across 46 different industries.

The portfolio was invested in 87% first lien senior secured debt, including 16% in PSSL, less than 1% in second lien debt and 13% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 10% and 100% of the debt portfolio is floating rate. As of September 30, 2022, the company had approximately $0.26 per share of spill over taxable income. I’ll now turn the call back over to Art.

Art Penn: Thanks, Rick. In closing, I would 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.

Q&A Session

Operator: We will take our first question from Paul Johnson from KBW.

Paul Johnson: I was wondering if you could just address one of the investments in the portfolio that also in the JV as well. There’s been some, obviously, developments with the company called Walker Edison post quarter to date. And I was just wondering if you could just kind of — if you could talk about any of the developments there as well as just the exposure in the portfolio as well as the JV. Just wondering how much exposure, I guess, you guys have there?

Art Penn: Yes. Thanks, Paul and good morning. We have about $12 million of Walker Edison in PFLT and about the same amount $12 million in the joint venture. It was marked at about $0.68 on the $1 as of 9/30. They did pay us cash interest on 9/30 or as of 9/30. So we — it was kept on accrual for that quarter. There are restructuring discussions going on. As we speak, we hope that by the time the next quarterly earnings happens in early February or as of December 31, we’ll have a little bit more color to share as to what is going on but the restructuring discussions going on and it could be a nonaccrual as of 12/31 and it may not be. We’ll see when the time comes.

Paul Johnson: Got it. And then can you just speak to, I guess, the overlap with the JV in the PFLT portfolio? And just kind of, I guess, remind me, is the attention and the intention in the JV to mirror essentially PFLT’s deal flow and have a high degree of overlap there? Or is there more of an objective of differentiation? I’m just — I guess I’m wondering what the degree of percentage overlap of the 2 portfolios there is between the JV and PFLT?

Art Penn: That’s a good question. And people use their JVs in different ways in our industry. For us, in PFLT, it’s really just an extension of PFLT to be able to write bigger bite sizes. So kind of very similar first lien senior secured floating rate portfolio. So you’ll see many deals that cross both the BDC and the JV. The JV does not take equity co-invest. So the equity co-invest stays in the BDC. It’s been — as we — as you know, the co-investment has been good. It’s been in the near 2.5x MOIC over 16 years. So the BDC retains the co-invest.

Paul Johnson: Got it. And then just one question on the liabilities. I know you guys have some bonds that have been kind of gradually amortizing down — that should be maturing in 2023. I’m just curious, is there, in the current market, any preference for if you were to be looking at refinancing and that may not be the case at the moment, I understand. But between, I guess, borrowing in the unsecured market versus the securitization, I’m just curious if there’s any — still any big cost differential between the 2? Or if that’s been closed if rates moving up and I guess, as well as the securitization even possible in this market?

Art Penn: Yes. So we do have some unsecured bonds that are due at the end of ’23. So we have a bit of time to figure out capital structure options. Over the long term, we think unsecured bonds should be a substantial piece of a diversified liability stack. We like having diversified pieces. Now that said, at certain times, it’s better to do a regular credit facility or securitization or bonds. PFLT did do some bonds in 2021 which were very attractive. We’ll evaluate the options over the course of the next year and try to figure out something. Some of the options could be kind of more long-term options. Some of the options could be more short-term in nature depending on where the markets are kind of as we get down the road here 6, 9 months.