PennantPark Floating Rate Capital Ltd (PFLT) 2022 Q2 法說會逐字稿

Good morning, and welcome to the PennantPark Floating Rate Capital's Second 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 Second Fiscal Quarter 2022 Earnings Conference Call. I'm joined here 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.

Thank you, Art. I would 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. Audio replay of the call will be available by using telephone numbers and pin provided in our earnings press releases 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 take 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 March 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.

From an overall perspective, in this area -- in this era of inflation, rising interest rates and geopolitical risk, we believe that we are well positioned as a senior secured first-lien lender focused on the United States. The floating rates on our loans can protect against rising inflation. We are pleased to be lending into the core middle market, where we are important strategic capital for our borrowers and are not commoditized. For the quarter ended March 31, our net investment income was $0.29 per share, which includes $0.01 of other nonrecurring income. Our credit quality remains solid.

With regard to the PSSL JV, with the CLO financing we completed earlier this year as well as additional capital commitments from PFLT and Kemper, the JV will continue to grow. The capital contributions from PFLT are targeted to generate a 10% to 12% return.

During the quarter, we announced an increased commitment to the JV of $57 million, which puts it on a path to growing JV to approximately $1 billion of assets over time. We believe that the increase in scale and the attractive ROE will enhance PFLT's earnings momentum.

Despite the market having a relatively light overall origination volume in the quarter, PFLT grew modestly and the JV grew by 10%, to a total size of $705 million. Even though the overall market was choppy, we are pleased with the resilience of our NAV. GAAP NAV was down only $0.08 per share and adjusted NAV, excluding the mark-to-market of our liabilities, was down only $0.02 per share.

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 also been resilient and tend to generate strong free cash flow.

As an aside, government services and defense is approximately 16% of the portfolio, inclusive of PSSL, and this sector should be a beneficiary of the geopolitical environment. In many cases, we are 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 is typically a defined game plan in place with substantial equity support from a private equity firm to substantially grow the company to add-on acquisitions or organic growth.

The loans that we provide are important strategic capital that fuels the growth and help set a $10 million to $20 million EBITDA company grow to $30 million, $40 million, $50 million 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 FY ['21], from inception to March 31, our $324 million of equity co-investments have generated an IRR of 27% and a multiple on invested capital of 2.7x.

Because we are an important strategic lending partner, the process and package of terms we receive is attractive. We have many weeks to do our diligence with care. We also restructured transactions with sensible credit 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 were so strong.

This sector of the market, companies with $10 million to $50 million of EBITDA is the core middle market. As we just highlighted, within the core middle market, we think our capital can add the most value and where we can get the strongest package of risk return is in the $10 million to $30 million of EBITDA range.

Our track as a PennantPark has been excellent for 15 years, but it took a step up and improved as we increased our focus on this portion of the market starting in 2015. The core middle market is below the threshold and does not compete with the broadly syndicated loan market or high-yield markets.

As many of you know, there has been an enormous amount of capital raised by some of our large peers. And as such, they are forced to focus on the upper middle market, which are companies with over $50 million of EBITDA. Those upper middle market companies can typically also efficiently access the broadly syndicated loan market.

As a result, in the upper middle market, our large peers need to aggressively compete with the broadly syndicated loan market and among themselves. This results in transactions where leverage is high, covenants are light or nonexistent, spreads and upfront fees are compressed and decisions need to be made quickly.

Additionally, from a monitoring perspective, we only receive financial statements quarterly. The argument you will hear is that bigger companies are less $50 million That is a perception and may make some intuitive sense, but the reality is quite different. According to S&P, loans to companies with less than $50 million of EBITDA had a lower default rate and a higher recovery rate than amongst the companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and trader monitoring has been an important part of this differentiated performance.

Our portfolio performance remains strong. As of March 31, average debt-to-EBITDA in the portfolio was 4.7x, and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.1x. This provides significant cushion to support stable investment income even as interest rates rise. These specifics are among the most conservative in the direct lending industry.

As of March 31, we had only 2 nonaccruals out of 125 different names in PFLT and PSSL. This represents only 2.5% of the portfolio at cost and 2.3% on market value. Our credit quality since inception over 10 years ago has been excellent. Out of 441 companies in which we have invested since inception, we've experienced only 50 nonaccruals.

Since inception, PFLT has invested over $4.8 billion at an average yield of 8%. This compares to a loss ratio of only 7 basis points annually. In our target markets, the outlook for new loans is attractive, with our experienced, talented and growing [team], our [wide] origination funnel was producing active deal flow.

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 $0.29 per share. including $0.01 per share of other income. Looking at some of the expense categories. Management fees and performance-based incentive fees totaled about $5.6 million. Taxes, general and administrative expenses totaled about $900,000 and interest expense totaled about $6.7 million.

During the quarter ended December 31, the net realized and unrealized change on investments was a loss of $1.8 million or $0.04 per share, net of associated tax provision. Due to our successful equity co-investment program, we had a tax provision of $3.8 million. Above that provision, our net loss of $1.8 million would have been a gain of $2 million or positive $0.05 per share.

Changes in the value of our credit facility and notes decreased NAV by $0.06 per share. Net investment income equaled our dividend. We sold 2.1 million shares this quarter through the aftermarket program above our NAV, which added another $0.02 per share. Consequently, GAAP NAV went from $12.70 to $12.62 per share.

Just at NAV, excluding the mark-to-market of our liabilities was $12.41 per share, down from $12.43 last quarter. Our entire portfolio, our credit facility and notes are mark-to-market under ASC 820 and 825, our 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.

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, is 1.4x. We have a strong capital structure for diversified funding sources and low near-term maturities.

Our portfolio remains highly diversified with 119 companies across 46 different industries. These now present as invested in the first-lien senior secured debt, including 14% in PSSL, less than 1% in second lien debt and 13% in equity, including 5% in PSSL. Our overall debt portfolio has a weighted average yield of 7.5%. 99% of the debt portfolio was floating rate at 82% as LIBOR floor. The 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 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 and has high free cash flow conversion. We capture that free cash flow primarily 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 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) We'll take our first question from Mickey Schleien with Ladenberg.

Yes. Art and Richard, hope you're well. Art, obviously, we're experiencing macro headwinds that we haven't seen for a long time. And you had a lot of experience in the credit markets. So I'd like to ask you where you see defaults heading this year and perhaps the next couple of years.

Thanks, Mickey. Thank you for participating. You're asking a great question, which -- it's hard to really obviously know. We've been in a really terrific environment recently with extraordinarily long defaults. So one would expect us to be as an industry or as sector to be heading back to a more normalized environment. We can go shoot, and lead in the different issues that potentially are challenging the economy and companies.

The direct lending industry, and we ourselves, at PennantPark, have had much lower default rates than either were leveraged alone or high-yield market, which we -- I think we all attribute to experience and hopefully knowing what to avoid and what not to avoid.

At PennantPark, we've had very limited default gm the 15 years, including through the GFC, the global financial crisis, the industrial energy downturn in the mid-teens and most recently, the pandemic. But I'd say the industry overall or the world overall is probably going to end up being a more normalized -- the more normalized default experience. We're getting to something like 2%, 3% a year. I think our industry is going to be probably better than that because I think we've got some very talented managers in our staff.

That's helpful, Art. And in terms of any warning signs ahead of defaults, which, as you mentioned, they really can only go up from where we are. With inflation running as high as it is, what trends are you seeing in your borrowers' revenues and their pricing power, and perhaps more importantly, their ability to defend their margins and service their debt?

So look, as we stated in the comments a few minutes ago, on average, our companies are covering their interest kind of 3x or so. So there's a lot of cushion in there for potential rising rates and potential rising interest expense from floating rates.

We -- and many of our peers, really, are focused on companies that have high EBITDA margins, which tend to indicate the companies are adding a real -- a lot of value. They can raise prices on their customers relatively easily. They've got reasonable control in their supply chains in this environment. We're always asking a question to the investment community, if this company goes away, does anybody really care? Who really cares about this company? And if so, what does it mean to the margins? What does it means to their ability to raise prices? What does it mean to their ability to manage their costs?

So I think our average EBITDA margin in the portfolio is something like 25%, which really indicates these are high value-added companies that do, by and large, have control of their costs. Of course, there's going to be outliers and in-portfolio, where you have over 100 names, which we have nearly about 119 names. Of course, there's going to be some weaker performers who are having some challenges. But based on the numbers we've seen, by and large, the companies are performing very well so far.

That's really interesting and helpful, Art. My last question is just in terms of when we consider how steep the forward curve is for interest rates, implying that risk-free rates are going to climb very meaningfully, and then we had spreads to that. When do you think borrowers will begin to push back?

I mean, we got this push and pull. Lenders may be thinking about their investments in terms of adequate risk-adjusted returns and borrowers are looking at claiming coupons. Do you think the market or -- the private lending market will be able to maintain spreads? Or are they going to give back some and look at things more on an IRR basis?

Yes. It's hard to say. I think one of the bigger things that may happen here and kind of enterprise value multiples have been at or near historical highs in many companies. It used to be unusual that a company would get sold for double-digit EBITDA multiple. 10x EBITDA used to be a very high enterprise value. Now that's kind of pedestrian. There's many companies that are getting bought and sold at 14x, 15x, 20x And kind of as the risk-free rate goes up, one would think that gravity would start to take some -- would start to take hold, and some of these higher multiples would end up coming down to earth a little bit.

What does that mean for us as a lender? It's a good question. I mean PFLT, we've kind of been in the mid-4s debt to EBITDA for a long time. We haven't really chased it just constitutionally. When debt-to-EBITDA grows above 5x, we become a little bit more skittish. We have to have a real conviction if we're going to go above 5x.

So we've managed to keep our focus in on capital preservation, focusing on cash flow and free cash flow. We haven't really been active in the ARR software world where -- it's been successful today, but we're still good old cash flow lenders.

Part of it is we're staying in a part of the market where you can do that, where our capital is not commoditized, where we are a strategic lending partner to these growing companies, where we're part of the first institutional capital, along with the private equity sponsor. And there's a real game plan to take that $10 million to $20 million EBITDA company and grow it and our debt capital is strategic to that.

So part of it is the place in the market where we are, where there's less competition, where our capital is not commoditized and where we become a real strategic partner in the deal. And by doing that, we can keep these reasonable multiples. We can get covenants. We have time to do our diligence, we get monthly financial statements and the package remains very attractive.

We'll take our next question from Ryan Lynch with KBW.

First question has to do with just what does the environment look like as far as portfolio activity or market activity, kind of that core middle market? Obviously, there's a lot of uncertainties out in the marketplace today that sponsors are looking at before they transact. I'm just curious are -- does it look like they're able to get over those uncertainties and you're seeing capital formation and deployment, which would then create deal opportunities for you? Or is it still a little bit lighter than we've seen in the past? Actually Q1 -- calendar Q1 was pretty light. Just curious what it looks like so far into Q2.

That's right, Ryan. Q1 was very light. Q2 is picking up. We are getting busier. We're not -- 2021 was kind of an anomaly that was ridiculously busy, and I think everyone was exhausted at the -- by the end of 2021 in some ways that we think that we had a mellow 2022 so we could all catch our breath a little bit.

I'd say we're coming back to a more normalized levels of activity. Is it going to be 2019 levels? I'd say that's still probably the base case, kind of think about 2019 in terms of activity levels pre-COVID. I'd still say that's probably kind of a rough estimate that we have for 2022.

So we're busy. We're not extraordinarily busy, but we're busy. And again, given where we are in the ecosystem kind of part of the first institutional capital with growth plans, the great thing about our economy here in America and how it operates is there's always interesting companies that are being created. There's always interesting companies where the next generation of ownership of management needs to come in and take it to the next level.

So there's always industrial logic. Now for that company, will that platform company sell for 10x EBITDA or 8x EBITDA? That's a question with higher risk-free rates or what, or what's the targeted IRR for the equity.

But there's always something going on. There's always there's this dynamic economy that we're privileged to be at the front row seat on. And we are -- every day, we're seeing new kinds of companies in industries and we have an opportunity to learn and to see what's going on in the economy to help be a value-added capital provider to fuel their growth.

So there's always something going on down where we are. We're kind of -- most of it is $10 million to $30 million of EBITDA. So there's always new things that we're learning and seeing. And kind of back to your question, what does that actually mean in terms of origination flow? I think you kind of got to think about it as 2019-type levels.

Okay. Yes. That's helpful and makes sense. The other question I had is kind of a sort of a follow-up on Mickey's question, maybe a little bit more graphic. Are you seeing any pressure yet for the deals that you guys are negotiating today and spreads on those fields of -- given where LIBOR so far is today and where those forward rates are? Have you started seeing any pressure on those spreads yet?

Well, the pressure. Well, the answer is we're not seeing a lot of movement over the last couple of months. Kind of we'll see where the more liquid markets go, broadly syndicated high-yield equity. And middle market does take its queue. It may take us a while to get through middle market.

The most important thing for us is the quality of the company, the quality of the borrower, the package of risk return that we're getting. In PFLT specifically, we've always valued safety of riding further the extra yield. And we're happy to get the upside for the equity co-invest. So we haven't seen much change so far in the middle market -- core middle market.

Okay. Understood. And then last question I had, in your prepared comments, you gave some good historical statistics under equity co-investment program, which has been a very successful part of the platform over the years.

I'm just curious, could the broader economic environment, whether that be some of the economic uncertainties that are out there or things like the trajectory of rising rates and the potential impact that, that had on equity valuations, does that affect your guys' willingness to deploy capital or how aggressive you want to be in that equity co-investment program? Or is that purely just based on you're looking at a bottoms up and a specific individual company and that outlook and whether that's a good business you think to be in or not?

Yes. I'd say we're more focused on entry multiple and potential growth of the company. So we may be fine lending to a company 4.5x debt to EBITDA, but are we -- do we want to do that equity co-invest at 15x? Maybe not, right? It may depend on what we think the growth trajectory of the company is would we be more apt to make that equity co-investment at 8x? Sure. It's an easier equity for an investor. Or are you creating equity over time at 8x?

You might be buying your initial platform at a higher multiple, but because the add-on acquisitions are lower multiples. The overall multiple might be lower. So we are a bottoms-up approach. We mesh that in with just being good value investors, and that's the value.

And look, as I just said a few minutes ago, with the risk-free rate rising, inevitably, x and multiples may come down. right? X and multiples may come down, and we have to model for that in our initial underwriting and assume kind of lower x multiples. And if you meet our threshold, i.e., we think we're going to get a 20% on our [wall] or so...

We're happy to do the coinvest. But if it doesn't, that's okay. Well catch you on the next one. And we don't feel never want to put ourselves in a position where we feel pressure is deployed. We want every investment to stand on its own 2 feet in a relaxed fashion and not planning to kind of just forced to kind of put the money out there. So I think that's one of the reasons our performance has been strong over such a long period of time.

(Operator Instructions) And we'll go to our next question from Kevin Fultz with JMP Securities.

Richard, first question, dividend income from controlled investments was $3.9 million for the quarter. I know the majority of that was an income from PSSL. But can you break out the other source of dividend? Did you come there? And whether those are reoccurring or onetime in nature?

Richard, you want to handle that one? We've got all PSSL with anything else new?

No, that's right. It's all from PSSL, the whole $3.9 million.

So that's -- when you guys get hurt, what do you do, now it's recurring and hopefully growing.

Okay. That's good to hear. And then my follow-up question, what are your strategies to grow NII as equity portfolio rotation? And as the quarter on the equity portfolio was about 8.7% the total portfolio, can you just remind us where your long-term target is for that bucket? Or what it is? And then also general expectations for the timing of that rotation if that has changed at all, increased market volatility.

Yes. So I think equity we kind of target to be in this portfolio, up to 10% of the portfolio on a cost basis. So we're well within that kind of mark-to-market basis. Obviously, it's hard for us to ever predict exit.

There is some government services and defense in there, that's a hot sector now and it should be. And that's a question on these kind of strong sectors. do you exit now? Or do you actually -- now would you wait a little bit. Not Immature, a little bit. So we are one of a few, few direct lenders that is highly involved in that space. It's kind of probably 15% of our overall platform across the various vehicles we have.

You might see some continued upward lift in the mark-to-market in those deals. And then the question is, for the sponsor, we're not in control in this case. Is the spot through E cell now, do the sponsors you sell now? Or do you like this positive trend kind of go for a little while?

So hard to say. You can see some clear winners in that portfolio, the percentage cost versus the mark-to-market. And that's a challenge that owners of company sponsors, after they were -- the company is doing so well, do you really want to sell? Or do you just want to lie for a little while?

So I'm not giving you a real answer because we obviously don't really know when these exits are going to happen, but we're kind of well within that kind of 5% to 10% range in that portfolio, some of the equity co-invest.

This concludes today's question-and-answer session. Mr. Penn, at this time, I'll turn the conference back to you for any additional or closing remarks.

I just want to thank everybody for being on the line today and your interest in PFLT. And we will talk to you next in early August after our next quarterly earnings. Thank you very much, and have a good day.

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