PennantPark Investment Corporation (NASDAQ:PNNT) Q4 2022 Earnings Call Transcript

PennantPark Investment Corporation (NASDAQ:PNNT) Q4 2022 Earnings Call Transcript November 17, 2022

PennantPark Investment Corporation misses on earnings expectations. Reported EPS is $0.14 EPS, expectations were $0.17.

Operator: Good afternoon, and welcome to the PennantPark Investment Corporation’s Fourth Fiscal Quarter 2022 Earnings Conference Call. Today’s conference is being recorded. At this time, all participants have been placed in a listen-only mode. The call will be open for questions-and-answers session following the speakers remarks. Thank you. It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Mr. Penn, you may begin your conference.

Art Penn: Good afternoon, everyone. I’d like to welcome you to PennantPark Investment Corporation’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 include a discussion about forward-looking statements.

Rick 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 Investment Corporation 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 and comment on our target market environment, provide a summary of how we fared in the quarter ended September 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, a detailed review of the financials then open up for Q&A. From an overall perspective in this market environment of inflation, rising interest rates, geopolitical risk and a potentially weakening economy, we are well-positioned as a lender focused on capital preservation in the United States where the floating interest rates on our loans can protect against rising interest rates and inflation. We continue to believe that our focus on the core middle market provides important attractive investment opportunities where we are important strategic capital to our borrowers.

In times of market volatility, our opportunistic credit 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 have differentiated institutional knowledge. It could be a company that we used to finance in a sector where we have domain expertise or a direct relationship with the management team or financial sponsor. We’ve been buying loans where we think we can generate double-digit or low-teens IRRs as the loans return to par in three years. We employed a similar strategy during the global financial crisis and generated excellent returns. In prior quarters, we outlined a game plan for growth of net investment income and dividends.

We continue to execute on our plan to increase long-term shareholder value, and I’m pleased to announce that the Board of Directors has approved another increase of our quarterly dividend of $0.165 per share payable on January 3rd to shareholders of record as of December 19th. Additionally during the September quarter end, we continued buying shares under our stock buyback program and purchased approximately 189,000 shares during the quarter for $1.2 million. In total, we have bought back $13.2 million of shares or 1.8 million shares. Some highlights for the quarter ended September 30th were as follows; our debt portfolio continues to benefit from rising base rates. Our weighted average yield to maturity increased to 10.8% from 9.3% last quarter.

Approximately 96% of our assets are floating rate compared to 47% of our liabilities that are fixed rate. Holding everything else constant, every 100 basis point increase in base rates translates into approximately $0.02 per share of NII. Another highlight was that our portfolio performed well during the quarter and we did not put any new investments on non-accrual. As of September 30th, we have one non-accrual, which represents 1% of the portfolio cost and 0% at market value. Thirdly, during the quarter we completed the amendment extension and expansion of the Truist Credit Facility. The size increased from $465 million to $500 million and the maturity was extended three years until 2027. Thank you to our lending partners for their confidence and support of the company.

And fourth, we continue to grow our PSLF joint venture. The joint venture grew from $608 million to $730 million during the quarter and continues to generate an attractive double-digit ROE for PNNT. We are targeting a $1 billion vehicle over time where we can drive substantial growth in NII at PNNT. 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, covenants are tighter and loan-to-value continue to be attractive. Our capital, which we believe is always value added is adding even more value in this environment. For the quarter ended September 30th, we invested $134 million in new and existing portfolio of companies and had sales and repayments of $176 million.

Now to review the operating results. For the quarter ended September 30th, core net investment income was $0.18 per share, including $0.01 per share and other income. This excludes onetime upfront financing costs from the amendment and extension of our credit facility. Our NAV was down due primarily to unrealized mark-to-market adjustments in our portfolio tied to the overall market and not due to fundamental credit factors. As you might expect most of the mark-to-market volatility came from our equity portfolio. Overall, GAAP NAV decreased by 6.9% comprised of a 3.6% decrease due to the fair value adjustments on our equity holdings and a 2.5% decrease due to the fair value adjustments on our debt holdings. The remaining 1% was attributed to fair value adjustments on our credit facilities.

With regard to increasing net investment income, our strategy remains focused on: number one, optimizing the portfolio and balance sheet of PNNT as we move towards our target leverage ratio of 1.25x debt to equity; number two, growing our PSLF JV with Pantheon to $1 billion of assets from approximately $730 million of assets at quarter end; and number three, rotating out of our equity investments over time and redeploying the capital into cash pay yield instruments. We have a long-term track record of generating value by successfully financing high-growth middle market companies in five key sectors. These are sectors where we have substantial domain expertise, know the right questions 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. It’s important to note that we do not have any crypto exposure in our software and technology investments. In many cases, we are typically part of the first institutional capital into a company or a founder, entrepreneur, or family 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 a private equity firm to significantly grow the company through add-on acquisitions or organic growth. The loans that we provide are important strategic capital that fuel the growth and help that $10 million to $20 million EBITDA company grow to $30 million, $40 million, $50 million of EBITDA or more.

We typically participate in the upside by making an equity co-investment. Our returns on these equity co-investments have been excellent over time, overall for our platform from inception through September 30. Our $355 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.5 times. With the current volatility in the broadly syndicated market, we have seen more private equity sponsors tap the private credit markets. We are selectively looking at these new opportunities and believe the vintage for these loans will yield compelling returns. Because we’re an important strategic lending partner, the process and packaging terms that 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 fees and 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, 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’re 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 a broadly syndicated loan or high-yield markets.

Many of our peers who focused on the upper middle market state that those bigger companies are less risky. That is a perception and 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 and higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring, have been an important part of this differentiated performance. The borrowers in our investment portfolio are performing well and we believe we’re well positioned for future quarters. As of September 30, the weighted average debt-to-EBITDA on the portfolio was 4.6 times and the average interest coverage ratio, the amount of which cash interest exceeds cash interest expense, was 3.6 times.

This provides significant cushion to support stable investment income even when interest rates rise, based on this substantial cushion even with the 200 basis point rise in base rates, and flat EBITDA our portfolio companies will cover their interest 2.3 times on average. Since inception PNNT has invested $7.3 billion at an average yield of 11%. This compares to a loss ratio of approximately 9 basis points annually. This strong track record includes our energy investments, our primarily subordinated debt investments made prior to the financial crisis, and recently the pandemic. With regard to the outlook, our new loans and our target market are attractive and this vintage should be particularly attractive. Our experienced and talented team and our wide origination of funnel, is producing active deal flow.

Our continued focus remains on capital preservation and being patient investors. We want to reiterate our mission, our goal to generate attractive risk-adjusted returns through income, coupled with long-term 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 through debt 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.

Rick Allorto: Thank you, Art. For the quarter ended September 30, net investment income totaled $0.14 per share including $0.01 per share of other income. Operating expenses for the quarter were as follows: base management fees, was $4.9 million. Interest and credit facility expenses were $13.7 million. General and administrative expenses were $1 million and provision for taxes was $200,000. During the quarter, we expensed $5.1 million of credit facility expenses related to the amendment and extension of our revolving credit facility. Excluding the $5.1 million of credit facility expenses, core NII was $0.18 per share. For the quarter ended September 30, net realized and unrealized change on investments and debt including provision for taxes was a loss of $44.1 million or $0.68 per share.

The reversal of the provision for taxes of $7.2 million or $0.11 per share was due primarily to the decrease in the value of RAM Energy. Change in the value of our credit facility, decreased our NAV by $0.08 per share. Core net investment income, exceeded the dividend by $0.015 per share. As of September 30, our NAV per share was $8.98, which is down 6.9% from $9.65 per share from the prior quarter. Our GAAP debt-to-equity ratio net of cash was 1.2 times. As of September 30, our key portfolio statistics were as follows. Our portfolio remains highly diversified with 123 companies across 32 different industries. The portfolio was invested in 51% in first lien secured debt, 11% in second lien secured debt, 12% in subordinated debt, including 7% in PSLF, and 26% in preferred and common equity, including 4% in PSLF.

The weighted average yield on debt investments was 10.8%. 96% of the debt portfolio is floating rate with an average LIBOR floor of 1%. As base interest rates rise, we are well positioned to participate on the upside. Holding everything else constant in the portfolio, a 1% increase in base rates translates into approximately $0.02 per share of NII upside per quarter. As of September 30, 2022, the company had approximately $0.71 per share of spillover taxable income. Now, let me turn the call back to Art.

Art Penn: Thanks, Rick. In closing, I’d like to thank our dedicated and talented team of professionals for their continued commitment to PNNT and its shareholders. Thank you all for your time today and for your continued investment and confidence in us. That concludes our remarks. At this time, I’d like to open up the call to questions.

Q&A Session

Operator: We’ll take our first question from Casey Alexander with Compass Point. Please go ahead.

Casey Alexander: Yeah. Hi. Can you hear me?

Art Penn: Yes. We can. Thanks, Casey.

Casey Alexander: Yeah. Okay. My first question is, I’m intrigued by your ability to buy first lien loans in the secondary market. Would these be new relationships, or would you be picking up some pieces of loans that you already have, or what — is there some sort of breakdown? And what percentage of your new originations in this quarter were as a result of buying first lien loans in the secondary market as opposed to direct origination?

Art Penn: Thanks, Casey. These are typically loans, where we feel like we have a differentiated viewpoint, where we’re not buying the market. It’s typically a company, we might have financed, when it was a little smaller in the core middle market and may be graduated to the broadly syndicated loan market. It’s in industries, where we think we have domain expertise. We know the management, we know the sponsor, and where we think we’re buying $1 for between $0.85 and $0.95. And we think there’ll be a potential pull to par over a two or three year time period, which gets you kind of the low to mid-teens kind of IRR. So all first lien to secure all credits that we feel are strong credits with good cash flow. It just happened to be a little bit of the baby’s gone out with the bathwater in a choppy market environment that we’ve had.

We €“ it’s been primarily in this €“ in terms of timing it’s been primarily more recently. I mean, I think we did a little bit in the quarter ended 9/30. It’s certainly a big piece of what we’re doing in the quarter that we’re in today.

Casey Alexander: Would you characterize these as broadly syndicated loans or are these private debt loans that are put out by private debt lenders?

Art Penn: No, these are loans where we can access in the broadly syndicated loan market. They trade with the big broker-dealers. And given the market environment they’re at a discount. So in virtually we think we have a different info hedged, but the BSL that in many cases graduated from middle market overtime.

Casey Alexander: Right. Okay. Thank you for that. Secondly, can you explain why PennantPark takes the $5 million amend and extend fee upfront when most platforms amortize that over the life of the credit facility? And if you’d like to make a case why that’s better for investors, I love to hear it.

Art Penn: Yeah. So that upfront fee, there’s a couple of ways you can do it. Accounting-wise, we are obligated under the way we account for our credit facility to take it upfront as a one-time versus amortizing that over the LIFO loan. So we are taking our pain today. But then, we don’t have to take the residual expense over the life alone. Also from a shareholder standpoint obviously this quarter meant that we as a management company earn no incentive fee. Again, that’s a shareholder-friendly way to do this. Going back in time and history back to a global financial crisis, we elected to mark our liabilities to market us. That was a very good matching mechanism for dealing with the SEC asset coverage ratio. And we’re still dealing with the residual of that.

The SEC would prefer that we don’t do that. And we prefer we don’t do that. You’ve seen these credit facilities now are marked closer to par, but we’re obligated to do the one-time fee, because this credit facility that we keep amending and extending is essentially the same from the accounting standpoint credit facility that we’ve had for many years. It’s the same lenders. It’s the same lead lender. The terms aren’t really changing other than the extension. So we’re obligated to take — to see as a one-time hit in this quarter. We do differentiate between core and non-core in our NII disclosure.

Casey Alexander: Okay. Thank you for that. And lastly…

Art Penn: Is that clear?