PennantPark Floating Rate Capital Ltd (PFLT) 2018 Q3 法說會逐字稿

Good morning, and welcome to the PennantPark Floating Rate Capital's Third Fiscal Quarter 2018 Earnings Conference Call.

Today's call 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.

Thank you, and good morning, everyone.

I'd like to welcome you to PennantPark Floating Rate Capital's Third Fiscal Quarter 2018 Earnings Conference Call.

I'm joined today by Aviv Efrat, our Chief Financial Officer.

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

Thank you, Art.

I'd like to remind everyone that today's call is being recorded.

Please note that this call is a property of PennantPark Floating Rate Capital and that any unauthorized broadcast of this call in any form is strictly prohibited.

Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release as well as 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 www.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.

Thanks, Aviv.

I'm going to spend a few minutes discussing financial highlights, followed by a discussion of the portfolio, investment activity, the financials and then we'll open it up for Q&A.

For the quarter ended June 30, we invested $165 million in primarily first lien senior secured assets at an average yield of 8.2%.

The average yield on new investments has increased during 2018, and has benefited from recent increases in LIBOR.

PennantPark's Senior Secured Loan Fund or PSSL continued to grow.

As of June 30, PSSL owned a $347 million diversified pool of 38 names with an average yield of 7.7%.

Again, the average yield on PSSL has also benefited from LIBOR increases.

Over the last several years, we have substantially grown our platform by adding senior and midlevel investment professionals in regional offices as well as New York.

The additional people in offices, combined with additional equity and debt capital we have raised, has significantly enhanced our deal flow.

This puts us in a position to be both active and selective.

The growth is evidence of this enhanced platform.

Net investment income was $0.31 per share.

Core net investment income, which excludes accrued non-payable incentive fees, was $0.28 per share.

Due to the activity level we are seeing, the increase in LIBOR and the growth of PSSL, we are pleased that our current run rate recurring net investment income covers our dividend.

Our earnings stream should have a nice tailwind based on continuation of these factors.

As of September 30, our spillover was $0.45 per share.

With regard to the Small Business Credit Availability Act, a reminder that our board approved the modified asset coverage that was included in the law, reducing asset coverage from 200% to 150% effective April 5, 2019.

The company has generated an excellent track record over the last 7 years, investing in lower-risk first lien senior secured floating rate assets.

We believe that such assets represent an appropriate risk profile that can be prudently leveraged under the revised statute to provide attractive returns for our investors.

Our successful operation of PSSL, which is today operating at the reduced asset coverage level contemplated by the new law, is evidence of this strategy.

We continue to work closely with our lenders, bondholders, rating agencies and stockholders to discuss our road map into the future.

We are pleased with the positive feedback we have received from various stakeholders.

Our primary business of financing middle market financial sponsors has remained robust.

We have relationships with about 400 private equity sponsors across the country and elsewhere, and we manage from our offices in New York, Los Angeles, Chicago, Houston and London.

We have done business with about 180 sponsors to date.

And due to the wide funnel of deal flow that we receive relative to the size of our vehicles, we can be extremely selective about what we ultimately invest in.

We are only investing in about 2% of the deals that we are shown.

We remain primarily focused on long-term value and making investments that will perform well over several years and can withstand different business cycles.

Our focus continues to be on companies and structures that are more defensive, have low leverage, strong covenants and high returns.

We are a first call for middle market financial sponsors, management teams and intermediaries who want consistent credible capital.

As an independent provider free of conflicts or affiliations, we've become a trusted financing partner for our clients.

We are pleased that we have been approaching this investing market with substantially more capital and resources in order to drive significantly enhanced self-originated deal flow.

This enhanced deal flow has meant that we can get more looks and be even more relevant to our borrower clients.

Being more relevant means that we can be increasingly selective about which investments we make as well as giving us the ability to be an important leader in transactions who can drive terms.

As a result of our focus on high-quality companies, seniority in the capital structure, floating rate assets and continuing diversification, our portfolio is constructed to withstand market and economic volatility.

The cash interest coverage ratio, the amount by which EBITDA or cash flow exceeds cash interest expense, continued to be a healthy 2.7x.

This provides significant cushion to support stable investment income.

Additionally, at cost, the ratio of debt-to-EBITDA on the overall portfolio was 4.4x, another indication of prudent risk.

In our core market of companies with $15 million to $40 million of EBITDA, our capital is generally important to borrowers and sponsors, we are still seeing attractive risk/reward, and we're receiving covenants, which help protect our capital.

Our credit quality since inception over 7 years ago has been excellent.

Out of 325 companies in which we have invested since inception, we have experienced only 5 nonaccruals.

On those 5 nonaccruals, we've recovered $0.98 on the dollar so far.

As of June 30, we had no nonaccruals on our books.

With regard to economy and credit cycle, at this point, our underlying portfolio indicates a strong U.S. economy and no sign of a recession.

Given our long-term track record, we believe that we're well positioned to weather different economic scenarios.

From an experience standpoint, we are one of a few middle-market direct lenders who was in business prior to the global financial crisis and have a strong underwriting track record during that time.

Although PFLT was not in existence back then, PennantPark as an organization was, and was focused primarily on investing in subordinated and mezzanine debt.

Prior to the onset of the global financial crisis in September 2008, we initiated investments which ultimately aggregated $480 million, again primarily in subordinated debt.

During the recession, the weighted average EBITDA of those underlying portfolio companies declined by 7.2% at the trough of the recession.

This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%.

As a result, the ROI on those underlying investments was 8%, even though they were done prior to the financial crisis and recession.

We are proud of this downside case track record on primarily subordinated debt.

In terms of new investments, we had another active quarter investing in attractive risk-adjusted returns.

Our activity was driven by a mixture of M&A deals, growth financings and refinancings.

In virtually all these investments, we've known these particular companies for a while, have studied the industries or have a strong relationship with the sponsor.

Let's walk through some of the highlights.

We invested $18.7 million in the first lien debt of Beauty Industry Group.

Beauty Industry Group provides hair extension and cosmetic products.

Gauge Capital is the sponsor.

Impact Group provides outdoor sales marketing and merchandising services to consumer packaged goods companies.

We purchased $20 million of a first lien term loan.

CI Capital is the sponsor.

Turning to the outlook.

We believe that the remainder of 2018 will be active due to both growth and M&A-driven financings.

Due to our strong sourcing network and client relationships, we are seeing active deal flow.

Let me now turn the call over to Aviv, our CFO, to take us through the financial results.

Thank you, Art.

For the quarter ended June 30, 2018, net investment income was $0.31 per share.

Core net investment income was $0.28 per share, excluding $0.03 per share of accrued, but not payable incentive fees.

Looking at some of the expense categories.

Management fees totaled $3.5 million.

General and administrative expenses totaled about $1.1 million.

And interest expense totaled about $3.9 million.

During the quarter ended June 30, net unrealized depreciation on investment was about $3.2 million or $0.08 per share.

Net realized losses were about $2 million or $0.05 per share.

Net unrealized depreciation on credit facility and notes was $2 million or $0.05 per share.

And income in excess of dividend was about $1 million or $0.02 per share.

Consequently, NAV went from $13.98 per share to $13.82 per share.

Our entire portfolio, our credit facility and notes are marked-to-market by our Board of Directors each quarter using the exit price provided by an independent valuation firm, exchanges or independent broker-dealer quotes when active markets are available under ASC 820 and 825.

In cases where broker-dealer quotes are inactive, we use independent valuation firms to value the investments.

Our portfolio is highly diversified with 83 companies across 22 different industries.

90% is invested in first lien senior secured debt, 4% in second lien debt, 6% in subordinated debt and equity, including 4% in PSSL.

Our overall debt portfolio has a weighted average yield of 8.7%.

100% of that portfolio is floating rate.

Now let me turn the call back to Art.

Thank you, Aviv.

To conclude, we want to reiterate our mission.

Our goal is a steady, stable and protected dividend stream, coupled with the preservation of capital.

Everything we do is aligned to that goal.

We try to find less risky middle market companies that have high free cash flow conversion.

We capture that free cash flow primarily in first lien senior secured floating rate debt instruments and we pay out those contractual cash flows in the form of dividends to our shareholders.

In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication.

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 Instructions) And we will take our first question today from Ryan Lynch with KBW.

You mentioned in your prepared comments that you guys have added people to the platform, that has kind of enhanced the deal flow.

Can you maybe just highlight some of the recent hires you guys have made across the PennantPark platform?

And exactly what they're really bringing to the platform and the deal flow side?

(technical difficulty)

I'm sorry, Ryan.

I've (inaudible).

We've had -- we've made investments in the U.S. and outside the U.S. in senior people.

We've added an office in Los Angeles, an office in Chicago, one of our partners moved to Houston, we've added an office in London, and we've beefed up the senior and midlevel team here in New York.

That has resulted in more looks, more relationships, new relationships coming into the firm.

We decided as we were beefing up our overall business and our first lien business, in particular, that we would -- that we needed a bit more feet on the street in order to get the looks and the relationships that we were hoping to get.

So those investments, which have been over the last few years, have really started to help with new relationships and more looks and more deals than we've ever had.

Okay.

That's helpful.

I thought -- Art, I thought, I stumped you there for a second.

We had some technical difficulties, my apology.

No, it's fine.

And then, moving to the -- some of the unrealized losses this quarter, were those driven by company, like -- I guess, what really drove the depreciation or unrealized loss?

I saw LifeCare had a little bit of markdown.

Were there any other specific companies that drove the bulk of those write-downs?

Look, it was about -- I think it was about $0.15 in total NAV diminution.

Now 2/3 of it were things that are -- number one, our bonds traded up.

So as you know, our accounting, basically when our bonds trade up, that hurts our NAV, that's because we try to match assets and liabilities in how we mark-to-market sale.

That was about 1/3 of our NAV diminution.

The -- another 1/3 of our NAV diminution was because we exited Sunshine Oil Sands, which was our one energy deal that we had.

It was our one nonaccrual that we had.

We just decided to exit and not have any energy name.

So we exited that.

So between the bonds being marked up, us exiting our one nonaccrual, our one energy name, that's 2/3 of the NAV effect that we had.

And then we had, like, one health care name, LifeCare, that continues to -- a small investment that continues to be trouble.

But we feel very good about the portfolio.

Our -- the companies by and large are performing well.

And as we said in our remarks, we see no signs of recession.

So we feel really good about the book.

Okay, that's helpful.

And then, you may have said this in the past, but I don't have it down anywhere.

Have you guys provided any sort of -- with the passage of the increased leverage limitation, have you guys provided any sort of target leverage range you guys intend to run at once that goes into full effect?

We have not provided a range yet, but as we said in our prepared remarks, we're speaking to all of our stakeholders and getting feedback, rating agencies, et cetera.

Look, I mean, if you look at PSSL as an example, that is leveraged more than 1:1.

And we believe we have among the lowest risk book of any BDC.

If you look at the deals we're doing, primarily first lien, if you look at the yields that we're generating, which are among the lower end of the BDC space, which indicate among the lower risk of the BDC space, we feel comfortable that we can operate comfortably with cushion above the 1:1.

But over the coming months, we'll be ascertaining and then deciding and, again, speaking to our stakeholders and we'll be coming out with a view as we talk to all these stakeholders.

But in the coming quarters, we'll give a precise -- or a more precise range of where we feel comfortable operating.

Okay.

And then, as we kind of trend up to that date in April of 2019, do you guys intend to kind of maybe continue to ramp up leverage or maybe ramp up leverage higher than when you -- where you've historically run at knowing that eventually that -- the ceiling is going to be get raised in April of 2019?

Yes.

So, look, we've always said, historically, even before the change in law, that given the assets that PFLT focuses on, 0.8x to 0.9x was not a problem given that the world seems to think these assets can be leveraged safely much more than that.

So certainly, higher leverage than where we are now.

And as we talk to our stakeholders over time, we'll ascertain a more -- we'll give you more formal guidance.

But as we've always said -- 0.8 to 0.9, these types of assets, as we've said, in the joint venture can get leveraged up to 2:1 and middle market CLOs can leverage up to 5:1.

So we certainly would always want to create cushion from whatever the law is.

But we feel really good about this book and type of assets that we're generating, the ability to book more leverage on them.

Okay.

And then just one more.

I know you mentioned on the last call, when talking about covenants on the debt that you guys have in your liability structure.

I know you said there is covenant in there [with your bob] if you get a 2-notch downgrade, you get about 20 basis point increase.

But that they've already reaffirmed that.

Are there any covenants in the -- your current credit facility today that would prevent you from going above 1:1 that would have to be amended?

Yes.

Well, on the credit facility, we're talking to our lenders and we are and we will and you've seen the whole BDC space get redone.

Credit facilities -- we're on process of speaking to our lenders.

And as we roll out, once we've spoken to our lenders and all the constituencies, we'll roll out a revised guidance, but we would anticipate amending our credit facility.

And we'll take the next question from [Raj Dome] with Leader Capital Markets.

What do you think about the economic environment in general?

And are there any specific sector that seems more attractive to you in the near future?

Thanks, [Raj], and we appreciate you being on, and we certainly appreciate the shareholder interest that we have in Israel and elsewhere.

So thank you for your interest.

The economic environment in the U.S. remains strong.

We would characterize it as a moderately growing economy.

We see EBITDAs of our underlying portfolio growing generally on a 5% to 7% a year.

We see no signs of a recession at this point.

We always underwrite as if there's going to be a recession.

And when we make investments, we assume there's a recession in the model and we make sure that we feel very comfortable about credits through a recession and we talked about how we did during the last recession, albeit the economic environment is strong.

What that means in terms of industries?

We're always focused on industries that are more recession resistant, that generate high free cash flow or that free cash flow can be used to pay down debt and to pay off debt.

So -- and the industries we're focused on right now are business services, distribution, health care services, software -- industries where we see very high free cash flow conversion.

We will now take the question from Mickey Schleien with Landenburg.

Art, because it's been so competitive out there, some BDCs are certainly having a tough time navigating the sponsored cash flow market.

But looking at PFLT, the portfolio has about doubled over the last couple of years.

And in that time, as you mentioned, the yield has gone up sort of in line with LIBOR, which implies you're maintaining your spread.

You mentioned the recent hires you made over the last several quarters.

I think it would be really helpful for us if you could give some insight as to how the origination team is structured, how it attacks the market, in order to help you accomplish these very good trends that we've seen the last couple of years?

So it's a good question, Mickey.

And I think that the real answer is our brand and our awareness in the market right now is greater than our capital.

We're kind of a moderately sized firm.

We're not one of these firms that manages $20 billion or anything.

So when you manage the type of capital that we have and you put our brand to market, which we think is very strong, and then you put very senior talented investment professionals against that market, in a region, we've been able to generate ample flow for our moderately sized vehicles.

So that's what's going on.

When we hire people into the platform, again, it's a different model.

We ask our investment professionals to do deals from end zone to end zone.

They're supposed to be helping originate it, diligence, underwrite it, bring it through investment committee, negotiate covenants and then monitor it -- monitor it once it's in portfolio.

So we ask them to do end zone to end zone.

And importantly in that is, their job is not to originate.

They don't get paid a commission to bring a deal in.

Their job really is, to be the line of first defense to protect our capital, to protect shareholders' capital and make good investments.

So when we hired our managing director on the West Coast, we said your title is not head of West Coast origination, your title is head of West Coast investment.

You're the line of first defense.

So that's emboldening him to not only originate, but also he and the team that we assigned to these deals have to own the credit risk and have to make sure they underwrite it properly.

I think what's really helped us underwrite and why we've had such a good senior debt track record is because, as you know, we started out 11 years ago as a mezzanine or subordinated debt shop.

And we underwrite senior debt the same way that we underwrite subordinated debt.

And we've had very nice track record underwriting subordinated debt.

So by definition, when we underwrite senior debt, which is usually less risky, we're using the same underwriting discipline.

So why we've had 98% recoveries and all that, I think in part and parcel is because of how we underwrite and how we structure.

That's really helpful and insightful.

I appreciate it.

And if I could just follow up.

In terms of gauging changes in risk tolerance over those last couple of years, can you talk about the trends over those last 2 years in terms of the share of sponsored deals in the portfolio and trends in borrower EBITDA and leverage multiples?

What I'm getting at is, these have been good solid results.

Is there embedded in there some additional risk that we should be aware of?

Look, it's a good question.

I think, the percentage of -- as the market has matured -- and look, we've been wrong, we were calling the peak of the credits outlook 4 years ago, right?

So we were perhaps overly cautious.

But over those last 3 years, 4 years, we've generally moved up capital structure across our platform.

The percentage of sponsor deals has grown.

We're now doing 90%, 95% sponsor-related versus what I'd say 80% at one point.

Why do we like the sponsor-related?

We like having big equity cushions beneath us.

And for us, it's been okay.

We've said, look, we're happy to have a safer book, and we're also okay taking a little bit less risk and a little bit less reward if the book is safer.

So higher percentage of our deals are sponsor, a higher percentage of our deals are senior secured.

And yes, leverage levels have crept up.

I'd say, for PFLT, we're now at 4.4x debt-to-EBITDA.

That's crept up from about 4x over the last kind of year or 2. So we're very aware of that.

We want to keep it in the low 4s generally.

But we like being at the top of the capital structure.

We like having a floating rate.

We like having a big, big equity check and in certain cases, second lien or subordinated check beneath us.

And what has happened, even though our leverage has crept up a little bit, the cushion of capital beneath us, whether it be second lien or subordinated debt or equity, has grown over the last few years.

And has borrower EBITDA remained relatively -- in terms of the target size of EBITDA of the borrowers that you're looking at, has that changed meaningfully over the last couple of years?

Yes, we've always been in the $15 million to $40 million EBITDA zone because once you get above $40 million of EBITDA, these borrowers can access the broadly syndicated market very efficiently.

So our average, if you looked at our book, it's probably an average of $30 million of EBITDA.

Some are closer to the low end of our range and some are, obviously, at the high end of our range.

But it's kind of generally remained stable.

All right.

And one last question, if I may.

When the higher leverage kicks in next year, have you thought about or you're contemplating bringing the senior loan fund on to the balance sheet?

The reason I ask is that it would increase in a sense transparency from the perspective of investors.

It would also make your nonqualified asset bucket larger, which could give you some opportunities down the road.

I understand you want to take care of your partners and perhaps there's a way to do that.

But I'd certainly be interested in understanding how you're thinking about that.

Yes.

So we -- the way the law came down, I mean, we already have upside to a credit facility for PSSL and an upside to our commitment, Kemper's commitment, right before the law changed.

The law change has, obviously, surprised us.

We've been -- we've had great success with PSSL.

We're kind of in the middle of -- we've invested over $300 million in it, it's a $600-plus million structure.

So we think over the next 9 months to 12 months, we can get PSSL fully levered.

Kemper has been a terrific partner for us.

We see -- there's a very [cemented] relationship, we see credit very similarly.

So our intention is to grow PSSL and get fully invested over the next 9 months, 12 months.

In 9 months, it's about April of '19, so we'll take a look at everything.

But we certainly like our relationship with Kemper and we'd like to continue it in a lot of different ways.

So we'll figure it out as we go.

In terms of transparency, I mean, the SEC requires and it's obviously in the Q. I think everything is in there.

All the investments, just like we would do in a statement of investments in a regular 10-Q, it's all there in our Q. If you'd like to get through with us or later, we're happy to go through it, but name by name, industry, cost per market value, yields, it's all disclosed in our Qs.

I'm aware it's in the Q, it's -- I get a bit more transparency, maybe not the best use of terms.

I was just referring to the fact that the SLS is a separate entity apart from the BDC.

But I understand your answer, and I appreciate your time this morning.

(Operator Instructions) We will now take a follow-up question from Ryan Lynch with KBW.

I just had one follow-up.

I noticed this quarter, you got -- in PSSL, there's about $27 million of investments purchased from PFLT.

Just can you provide a little background on that?

Were those loans that were just recently originated by PFLT, that were just kind of dropped down there?

Or were those older loans that have been on PFLT's book for several quarters that were sold down into PSSL?

Can you just give a little background and, I guess, thought process of how you guys are thinking about moving investment into PSSL, why that occurs?

Yes, it's a great question.

I mean, some deals go right into PSSL.

Some deals need to be seasoned by PFLT due to rules and regulations, routes of originated deals.

So in certain cases, PFLT has to buy it and hold it for a while and season it and then it can go into PSSL.

Some are just deals we've had that have grown and PSSL, i.e., Kemper really like them and want them to go into PSSL.

So it's a combination of 3 ways the deals find their -- there are 3 ways that deals find their way into PSSL.

One is funds.

Two, is it needs to be seasoned for a while on PFLT.

And three, is we've just grown the position in PFLT and PSSL wants it and it's very efficient for us to move it over to PSSL.

And that's all by the fair market value, whatever the valuation firms come up with the value, it's all based on that.

So it's fair to assume then going forward we can expect most likely some level of sales from PFLT's balance sheet into PSSL going forward?

That's right, that's right.

Look, we really like PSSL.

Like I said, we really like the relationship with Kemper and we like the efficiency of capital.

And we think we got another 9 months, 12 months to kind of get it fully deployed and then it'll be very accretive to shareholders.

And we'll pick our head up, and we'll see where we go.

But it's -- we're very pleased with the financing on Capital One, so when it ain't broke, don't fix it.

And that concludes our question-and-answer session.

I'd like to turn it back to Art Penn for any additional or closing remarks.

I just want to thank everybody for being on the call today.

Thank you for your interest.

We'll be talking to you in mid-November, which is when our next quarterly call happens.

A reminder, it is our 10-K.

So the call happens and our K filing happens a little bit later than our normal Q filing would happen in November.

So look forward to speaking to everybody, and we'll talk to you soon.

Thank you very much.

And thank you very much.

That does conclude our conference for today.

I'd like to thank everyone for your participation.

And you may now disconnect.