PennantPark Floating Rate Capital Ltd (PFLT) 2022 Q1 法說會逐字稿

Good morning, and welcome to the PennantPark Floating Rate Capital's First Fiscal Quarter 2022 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.

Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's First Fiscal Quarter 2022 Earnings Conference Call. I'm joined today by Richard Cheung, our Chief Financial Officer. Richard, please start off by disclosing some general conference call information and include a discussion about forward-looking statements. Richard?

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. 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 that we ask you to 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.

Thanks, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ended December 31, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials and then open it up for Q&A.

Our net investment income grew to $0.33 per share, which includes $0.05 of other nonrecurring income. Our credit quality remains solid. We're pleased that we've grown NII through growing the assets on balance sheet at PFLT as well as that of our PSSL joint venture. Now that we have reached the zone of our target debt-to-equity ratio of PFLT, we remain focused on 2 additional prongs to our strategy to grow NII: number one, growing our PSSL JV with Kemper to enhance overall ROE at PFLT; and number two, rotating the equity value in our portfolio that has come from our strong equity co-investment program into cash-paying debt instruments.

With regard to the PSSL joint venture, with the CLO financing we completed earlier this year as well as additional capital contributions from PFLT in Kemper, the JV will continue to grow. The capital contributions from PFLT are targeted to generate a 10% to 12% return. We're on a path to grow PSSL to over $700 million in the current quarter. We have started discussions with Kemper to increase the JV to have approximately $1 billion of assets over time. We believe that the increase in scale and the attractive ROE will enhance PFLT's earnings momentum. As part of our business model, alongside the debt investments we make, we selectively choose to co-invest in the equity side by side with the financial sponsor. Our returns on these equity co-investments have been excellent over time.

Overall for our platform from inception through December 31, our $297 million of equity co-investments have generated an IRR of 29% at a multiple on invested capital of 2.9x. In a world where investors may want to understand differentiation among middle-market lenders, our long-term returns on our equity co-investment program are a clear differentiator. We have implemented a significant portion of the NII growth strategy to date. Investment portfolio of PFLT increased by approximately $100 million in the quarter to $1.18 billion from $1.08 billion. PSSL's investment portfolio also grew this quarter to $642 million from $565 million, an increase of $77 million.

We're focused on the core middle market, which we generally define as companies with between $10 million and $50 million of EBITDA. The target market where we think we add the most value and where we get the strongest package of risk-return is in the $10 million to $30 million of EBITDA range. We like the core middle market because it is below the threshold and does not compete with a broadly syndicated loan or high-yield markets, unlike the upper middle market.

As such, we do not compete with market where leverage is higher, equity cushion lower, covenants are light, wide or nonexistent, information rights are fewer, EBITDA adjustments are higher and less diligence and the time frame for making an investment decision is compressed. On the other hand, where we focus in the core middle market, generally, our capital is more important to the borrower. As such, leverage is lower, equity cushion is higher. We have real quarterly maintenance covenants. We receive monthly financial statements to be on top of the companies. EBITDA adjustments are more diligent and achievable, and we typically have 6 to 8 weeks to make thoughtful and careful investment decisions.

According to Lincoln International, the covenant lite share of direct lending loans increased from 20% in Q3 2021 to 35% in Q4, a 15% increase in just 1 quarter. We believe that this was driven primarily by the growth of the mega multibillion-dollar direct loans done by the largest direct lenders who compete heavily amongst themselves as well as the broadly syndicated loan market.

Less covenant protection may ultimately have important ramifications down the road to outcomes. Virtually all of our loans in core middle market had meaningful covenant packages, which protect lenders. 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 those loans to companies with higher EBITDA. We believe that the meaningful covenant protections of the core middle market have been important part of this differentiated performance.

Our portfolio performance remained strong. As of December 31, average debt-to-EBITDA in the portfolio was 4.6x, and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.3x. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. As of December 31, we had only 3 nonaccruals out of 120 different names in PFLT and PSSL. This represents only 2.9% of the portfolio at cost and 2.5% at market value. The portfolio is highly diversified with 115 companies in 46 different industries.

Our credit quality, since inception over 10 years ago, has been excellent. Out of 434 companies in which we have invested since inception, we have experienced only 15 nonaccruals. Since inception, PFLT has invested over $4.7 billion at an average yield of 8%. This compares to a loss ratio of only 7 basis points annually. Many of our portfolio companies are in industries such as government services, health care, technology, software, business services and select consumer companies where we have meaningful domain expertise.

The outlook for new loans is attractive. We have been busy. We have been as busy as we have ever been at 15 years in the business, reviewing and doing new deals. With our experienced, talented and growing team, our wide funnel is producing active deal flow that we can then carefully and thoughtfully analyze so that we can be selective as to what ends up in our portfolio.

Let me now turn the call over to Richard, our CFO, to take us through the financial results in more detail.

Thank you, Art. For the quarter ended December 31, net investment income was $0.33 per share, including $0.05 per share of other income. Looking at some of the expense categories, management fees and performance-based incentive fees totaled about $6.1 million. Taxes, general and administrative expenses totaled about $900,000, and interest expense totaled about $6.6 million.

During the quarter ended December 31, net change in unrealized depreciation on investments, net of any associated tax provision, was a loss of $5 million or $0.13 per share. Net realized gains were about $3.1 million or $0.08 per share. And changes in the value of our credit facility and notes increased NAV by $0.09 per share. Net investment income was higher than the dividend by $0.04 per share. Consequently, GAAP NAV went from $12.62 to $12.70 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.43 per share, flat quarter-over-quarter.

Our entire portfolio, our credit facility and notes are marked-to-market by Board of Directors each quarter using exit price provided by an independent valuation firm, exchanges on independent broker-dealer quotations, 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 debt-to-equity ratio was 1.5x, while net debt-to-equity, after subtracting cash, was 1.4x. We have a strong capital structure, with diversified funding sources and no near-term maturities. We have a $300 million revolving credit facility maturing in 2026, with $257 million drawn as of December 31, $97 million of unsecured senior notes maturing in 2023 and $228 million of asset-backed debt associated with PennantPark CL1 due 2031.

During the December quarter, PFLT issued an additional $85 million of the 4.25% 2026 unsecured senior notes, bringing the total principal balance to $185 million. The add-on notes were issued at a premium, resulting in a yield of 3.875%. The proceeds from this note issuance provided additional capital for investments. Our portfolio remains highly diversified with 115 companies across 46 different industries. 87% is invested in first-lien senior secured debt, including 13% 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 7.5%. 99% of the portfolio is floating rate and 84% of the portfolio has LIBOR floor. Average LIBOR floor is 1%.

Now let me turn the call back to Art.

Thanks, Richard. To conclude, we want to reiterate our mission, our goals of 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 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.

And we'll take our first question from Mickey Schleien with Ladenburg.

Art, did you accrue any past due interest or any other nonrecurring items into interest income this quarter at PFLT?

I think I understand your question. I don't think we did. Just -- are you getting at some specific, Mickey?

I'm just doing the math. The effective yield looks a little higher than expected.

Yes. Look, I think the growth of the joint venture is certainly helping out.

All right. And what caused the increase in other G&A expense this quarter? And what's the outlook for that line item?

Richard, do you want to have this one?

Sure, Art. The G&A increased this quarter because the funnel has grown in size and the activity volume. So G&A expenses are made up largely of audit, expense, legal, valuation firm, sub administration services and those fees have gone up because of the increase in size and volume of activity. So we do expect the G&A to continue to clip at this pace that we have in the first fiscal quarter for the remainder of the year.

Okay. Does your on-balance sheet credit facility and securitization measure collateral at fair value or at cost?

It's a classic CLO structure based on cost.

And the credit facility, Art?

The credit facility on cost as well.

Terrific. And how much leverage does the SLF's credit facility allow, Art?

It's an SPV. So we had 2 kinds of pieces of debt. It's a joint venture. We have our securitization CLO, and we have an SPV, and they kind of work hand in glove. And you get kind of an advance rate based on -- certainly in the SPV, you get an advance rate based on the type of collateral. So it can permit kind of essentially 2:1 debt to equity in that SPV. The CLO itself can permit more than that as a typical CLO can.

And our next question comes from Kevin Fultz with JMP Securities.

Clearly, the December quarter was really nice from a capital deployment standpoint, growing assets on balance sheet as well as PSSL. I know over the past year you've described the vintage as very attractive. Just curious how you describe the deal-making environment and attractiveness of deals here in 2022?

Yes. So first, let's -- a good question, Kevin. Thank you. Let's just talk about pacing. 2021 was a blistering pace in deal activity, particularly towards year-end. Number of things came together and make 2021 extraordinarily active. Is 2022 going to be as active as 2021? Right now, it looks like that's unlikely. The year has started out as a typical year, where the first quarter is relatively slower -- first calendar quarter is relatively slower as people still digest and still are recovering from a very active calendar Q4. So we think this will probably be a more normalized year. Is that going to look like 2019? That might be -- if you said, okay, is 2019 activity the base case? Probably. I think there'll be probably a reasonable expectation to model the 2019 kind of pacing for 2022 versus the 2021 pacing for 2022.

Second part of the question is how do you think about it from a vintage standpoint and the types of deals that you're seeing. I think we're pleased, at least at PennantPark, that we're focused on an area of the market that is not getting the attention and the focus, and therefore, we can be much more important for the borrowers. Where is the focus and the intention, and you're seeing it in all the articles that everyone reads and some of the research you all provide, which is that upper middle market where the Goliath investment management firms have very massive pools of direct lending capital. And they are competing heavily among themselves, and they are competing heavily against the broadly syndicated loan market. And their pitch, as you all know, is their leading share of the broadly syndicated loan market, and that's great.

Up there at that upper middle market decision making is compressed. Leverage is higher. There are no covenants. The information rights are far fewer. They only get financial statements every quarter. And for us, that's all very good because it leaves the core middle market or even the lower middle market a big opportunity for people like us where our capital has meaning to the borrower, where we have 6 to 8 weeks to do proper due diligence, where we can really understand what we're buying, whether we're more important to the borrower and as such. The yields are higher. The upfront OID is higher. The covenants, we get quarterly maintenance tests that have meaning in all cases. We get monthly financial statements.

So for us, that whole move in the upper middle market is creating this very nice window for us. And our target market today is kind of we start out with these companies that start out with between $10 million and $30 million of EBITDA and they all have a game plan for growth, whether it be organic growth or inorganic growth. Our debt capital can fuel that growth, and we can participate in the upside through the equity coinvest. So we take that $10 million to $30 million EBITDA company along with the sponsor. We grow it to $40 million, $50 million, $60 million, $70 million, $100 million of EBITDA. It then goes up to that upper tier of the market. We exit the debt, and we're still riding the equity coinvest. So it's been a very good place for us to be. Our returns have been over the last 5, 6 years, excellent because that's kind of the niche we're in, and the niche is getting bigger as the big guys go up.

Great. That's really helpful color there, Art. And then just a follow-up question relating to interest rate sensitivity. Could you provide the weighted average LIBOR floor for floating rate investments?

Yes. It's about 1%, Richard, right?

That's right. An average -- LIBOR floor average is 1%.

Congratulations on another strong quarter.

Thanks, Kevin.

And we'll take our next question from Paul Johnson with KBW.

Just going back to Mickey's question on the portfolio income. I know you said it doesn't sound like there's really that many nonrecurring items in there. If I'm looking at it right, I think it was roughly $17 million of interest income this quarter. It's like roughly like a 7.5% yield on the debt portfolio. Do you see that as pretty sustainable for where the portfolio is at today going forward?

Yes. Look, as long as our credit quality remains strong, we do have some more rotation to do in that equity coinvest portfolio. We're going to talk more about Pivot later at PNNT, but PFLT does have a piece of Pivot. And so we should continue to have some more equity rotation. And certainly, as we upsize this joint venture with Kemper, we're very hopeful that we can continue to grow recurring NII to clearly have the case where we're repeating the dividend handily on a consistent basis.

Great. My other question, which is on an investment in the portfolio. Just curious on Marketplace Events. I think that's been onto nonaccrual for some time on your books. The mark on that has been kind of steadily going up over time. What -- do you guys have any kind of update on that company or outlook as far as what's going on there?

Yes. And you can see it in the market, the trade show business, home goods, things of that nature, it's a really well-run company. We took control of it shortly after COVID. Excellent management team. And they've operated very well through COVID and managed to cut their costs appropriately, still keep the business going, maintain strong cash position. And now that we hopefully are coming out of COVID in a more fulsome fashion, we think it's well positioned to bounce back to what it was pre-COVID, and hopefully more and higher as they operate. They're the leader in their industry. We think they're going to end up doing some add-on acquisitions that can continue to help grow EBITDA over the coming quarters and year or 2. We hope and we expect EBITDA to bounce back very nicely.

Okay. And then just last question. Do you guys have any update on an estimated spillover amount from this quarter?

Richard, over to you. I don't think there's anything major since the last quarter. We announced every year once a year in our September Q what the spillover is. Richard, do you want to refresh us as to what that was?

Yes. We could get back to you on that after this call.

Sure.

It's in the Q. I'm going to say it's $0.20 a share, something, maybe $0.30, something in the $0.20 a share.

Sure. Yes. I think it was like $0.22 last quarter.

Yes. Yes.

Okay. Yes. I appreciate that. That was our only question.

Yes. And that would have grown this quarter with the [overloading] that we did, right? [It's in the press release] was always on September -- on the September and add that price on to whatever it was and probably be good enough for now. We can follow up after.

And we will take our next question from Mickey Schleien with Ladenburg.

Art, just to follow up on that average floor in the debt portfolio. I think you said it was 1% on the balance sheet. Is it similar in the senior loan fund as well?

Yes. Yes. Look, the typical floors are 1% at least in our portfolios. And I think we have a chart in the Q what it would mean if LIBOR -- if interest rates go up 1%, I think it had something about -- hurting NII about $0.01 a share a quarter.

Right. Art, how do you feel about the scope to term out some of the credit facilities balance and help protect the balance sheet against rising interest rates?

Yes. It's something we think about. It has to do with credit rating. It has to do with the markets. We like the securitization market, by the way, as you know. CLO market is great long-term capital and it's -- you can do some of that fixed. Most of it is floating, but we also like to be matched. We also like to be matched. So it's a plus and minuses. I think as interest rates go up, yes, we'll probably be hurt a little bit on NII. I think the growth of PSSL, the equity rotation is going to mitigate that and more and at least will be matched on the upside if and when rates get there.

Understand. Last question, Art, how do you feel about the portfolio company's ability on average to pass through inflation on to their customers?

Yes. It's something that's sort of core of what we -- how we underwrite and how we think about the companies that we invest in. We're always asking ourselves the question, if this company goes away, does anybody really care? Who cares if this company goes away? Which really brings you to kind of how important are these companies to their customers? Do they have a price -- can they raise prices in a relatively easy fashion? Whether customers accept those price increases? The average EBITDA margins in our portfolio were north of 20%, which, by definition, means they're getting really attractive margins and they're really well positioned with their customer base.

So the vast majority of the companies that have asked for price increases so far have gotten them. And if they haven't asked for it, they are asking for it as we speak. And in this environment, these companies are getting that. They're important to their customers. By the way, the environment does help. Everyone knows costs are going up, and it's not unreasonable for companies to be asking for price increases in this environment. So we've had a pretty good experience thus far with pricing increasing in the portfolio.

And our next question comes from David Miyazaki with Confluence Investment Management.

Congratulations on the quarter. Just kind of wanted to talk a little bit about -- I mean, since you guys brought out PennantPark Floating, you have this over strategy pointing your assets towards floating rate coupons. And I think that's something that has become more widely adopted across the industry. So I'd just like to hear your perspective on how the LIBOR floors may change as we go into a period when -- if you look at the Fed's dot chart, we should be approaching LIBOR or the reference rate around 100 basis points at the end of this year. Historically, I don't think that a lot of people have moved their floors up while the Fed is tightening and they worry more about it when the Fed is coming down. So could you kind of talk about your views on that?

Yes. It's interesting. I mean we'll see how the market evolves, David. Historically, when we've had a rising LIBOR, and you can go back as short as I think a couple of years ago, I think LIBOR was 2.7%, 2.8% not too long ago. There was some erosion of the LIBOR floor. The LIBOR floors were getting taken out of the documents. And that's some. I think the vast majority of the deals still then, when LIBOR was at 2.7%, still had LIBOR floors. And I guess, by the way, they're going to SOFR floors as we see how the things go in the coming months. So if you look at the history, floors, seem like they're a permanent part of the landscape, although you still see some erosion when SOFR or LIBOR are far above what a typical floor would be. That's what we've seen. But it will be interesting to see how things develop this time around if we do indeed get above 100 basis points in terms of short-term risk-free rates.

Do you ever have the ability -- let's go back to that period you talk about when LIBOR was 2% plus. Is it something that you have the ability to negotiate for a higher floor when people aren't worried about lower rates? Is that something that you can extract in negotiations? Or is that just generally not happening?

Yes. It's a great question. And yes, the other side of the coin, you're right, is when LIBOR is over 2%, people are happy to give you a 1% floor because it sleeves off their vest, right? So -- and is that an opportunity to go for 1.25% or 1.5%? And that's certainly something we think about at that time. I think it's really -- it just comes down to the negotiation at that time, how much they need you and what their other options are. And PFLT, specifically -- we specifically seek out the lower-risk portion of the direct lending market. That's always been for PFLT, what we're looking to do, okay, to take a lower risk at a lower reward, have a lower expense ratio.

And for that lower risk investor who wants to really sleep well at night, PFLT should be a good place for them to think about. So I would imagine, in the strategy, if -- even in a higher short-term rate environment, we're still going to be trying to select the absolute best credits and willing to take a lower yield for that comfort of sleeping at night. So probably in this strategy, maybe we can get it from time to time, but I wouldn't count on it since we specifically, in this strategy, want absolutely the best credits.

Okay. That's helpful. I wanted to kind of extend a little bit on the concept that you talked about with the ability of your borrowers to pass inflation pressure through. Because of the LIBOR floors, to some extent, your borrowers haven't benefited as the Fed has dropped rates down to 0, right, because they're the floor? Which has the opposite effect of kind of insulating them from the first floor heights in the Fed raising the [Kubernetes] rate. So how would you feel -- is there enough pricing power in your borrowers' model to handle kind of this duality of rates rising -- LIBOR rising above 100 basis points, at the same time having to push inflationary costs through to customers? Is there enough room in that 20% EBITDA margin?

Yes. I mean we think so. So far it's working. So far, the price increases and they could be a 5% or 7% or 10% or two 5s or whatever. I mean everybody's got their own way of doing their price increases. They've been sticking. They've been sticking out. When we look at our credit stats, we're over 3x interest coverage, 3.3x interest coverage. So we feel like we're in kind of an okay place. Sure, I wish we had the upside as the Fed -- we had the upside of the lender as the Fed was rising, but -- raising rates, but we've had the benefit of very healthy yield as they were lowering and even through the pandemic. So we can't really complain about it.

And we think if we're picking the right credits, they have the right cushion built into the credit stats and if we can find credits where they're important to their customers. And that's really kind of hones in on kind of why we're focused today on 5 key sectors. That's where there's very high -- very good high free cash flow margins, with a good margins period and where we know the right questions to ask. So as we kind of think about ourselves and how we try to improve over the years, it's really kind of focusing in on those sectors that really provide those kinds of EBITDA margins.

There are no further questions at this time. I will now turn the conference back to Mr. Penn for any closing remarks.

Thanks, everybody. We really appreciate your attendance today. And next time we chat, it will be in early May after our March quarter. So thanks, everybody. Take care.

This concludes today's call. Thank you for your participation. You may now disconnect.