Pennantpark Investment Corp (PNNT) 2008 Q1 法說會逐字稿

Good morning, and welcome to PennantPark Investment Corporation's First Fiscal Quarter 2008 Earnings Conference Call.

At this time, all participants have been placed on listen-only mode. The call will be open for a question and answer session following the speaker's remarks.

(Operator Instructions)

It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and CEO of PennantPark Investment Corporation. Mr. Penn, you may begin your conference.

Thank you and good morning, everyone.

I'd like to welcome you to our First Fiscal Quarter 2008 Earnings Conference Call and our third earnings call as a public company. I'm joined today by Aviv Efrat, CFO. 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 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 by using the telephone numbers and pin provided in our earnings press release.

I 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 CEO, Art Penn.

Thank you, Aviv.

For the quarter ended December 31, 2007, it was an active one for PennantPark. We invested $71 million in five different companies and increasingly diversified the industries. Our exposure to more [definitive] industries such as healthcare and energy increased substantially.

In our three quarters of operations, we've paid total dividends of $0.58 a share. We paid a dividend of $0.14 in our first quarter of operation, and $0.22 per share in each of our second and third quarters, and at September 30th and December 31st respectively.

As interest rates decline, we believe that companies that have a healthy dividend, backed up by a strong portfolio will ultimately be viewed favorably by the equity capital markets.

The credit correction has helped us make even faster progress, becoming a first call for a number of middle market financial sponsors, management teams, and intermediaries who want consistent credible capital in the middle of their capital structures.

As an independent provider free of conflicts or affiliations, we have rapidly become a trusted financial partner for our clients. Despite strong deal flow, we view ourselves as value investors. We are not a production shop focused on meeting quarterly origination goals.

The correction has also, unfortunately, impacted the broker-dealer quotes by our existing portfolio, which is primarily in more liquid instruments of larger, inherently less risky companies.

As you've all been reading about it in the newspaper, the quoted market prices for liquid first-lien secured debt have continued to move lower over the last few weeks. To date, all of our investments are performing, and not one has breached the covenant, let alone, defaulted.

The correction that is going on in the market today presents a wonderful long-term opportunity for PennantPark. We continue to be among the most liquid companies in the BDC space, and have the capital resource system to make long-term investment decisions based on fundamental value.

Risk reward is the best it has been in years, and PennantPark is uniquely positioned to take advantage of the chaos. In the last two quarters after the start of the market correction, we deployed $112 million in our core assets at attractive risk rewards.

We still have much more [dry power] to invest in this increasingly attractive market.

As of December 31st, we owned about $149 million of lower risk liquid first lien secure debt. Combined with our undrawn credit facility, we have about $307 million of liquidity, and have a total asset size of approximately $508 million as of December 31st, 2007.

In other words, we still have ahead of us, the deployment of 60% of our total purchasing power, much better risk rewards than we have seen in many years. As investors, the late 2007, 2008, and 2009 vintage years could be the best we have seen since the 2002-2004 time period.

With $112 million already invested after the start of the market correction, and the ability to invest another $307 million, we have the opportunity to have a portfolio that's invested over 80% after the start of the market correction.

For the quarter ended December 31st, we invested $71 million in five investments in our core asset classes, which include second lien secure debt, subordinated debt, and equity. Three of these were new companies in our portfolio, and two were existing companies in the portfolio.

Our new core debt investments during this quarter had an average yield of 12.9%.

Let's walk through some of the highlights.

We have invested $23 million in second lien secured debt of Brand Energy and Infrastructure. Brand is a diversified provider of specialty services to North America's energy markets. The company focuses on scaffolding, industrial coatings, and insulation, and operates in five key energy sectors including refinery, petrochemical, oil sands, power generation, and offshore oil and gas.

The company is controlled by a financial sponsor, First Reserve.

Generics International is a fully-integrated developer, manufacturer, and marketer of a broad line of prescription, generic, and over-the-counter pharmaceuticals with a focus on attractive specialized niche products including generic liquid and semi-solids.

We purchased $12 million of second lien secured debt to back the company's acquisition by Apax Partners.

Interdynamics Holdings is the leading provider of replacement air conditioning refrigerant for the DIY Do-it-yourself automotive repair aftermarket. We invested $20 million of subordinated debt to back an add-on acquisition by the company.

Arsenal Capital Partners is the company's financial sponsor. More about Interdynamics in a moment.

Sheridan Holdings is a leading provider of the niche physician staffing outsourcing services to hospitals in the US. Sheridan holds the number one market share in anesthesia, and the number two market share in neonatology. We invested $12 million in second lien secured debt. Bellman and Friedman is the Financial Sponsor.

We added $5 million in the second lien secured debt of Specialized Technology Resources. STR is the leader in the consumer testing and inspection market as well as the leading global provider of solar encapsulates.

I want to spend a minute on Interdynamics, to highlight the kind of opportunities we're seeing in this market. Interdynamics is the leading provider of replacement air-conditioning refrigerant for the DIY automotive aftermarket.

For instance, if the air conditioning unit in your car needs a recharge, instead of going to your local mechanic who would charge $125 to $150, you can go to AutoZone, Advance Auto, a Pep Boys and most other automotive aftermarket stores and buy the Interdynamics product for $20 to $40 and change the refrigerant yourself.

This is a typical middle market company, and a niche that we like to finance. The company has high free cash flow conversion, with capital expenditure and working capital requirements a small number relative to the EBITDA.

Our $20 million of subordinated debt was to a comfortable leverage level, and had an overall yield of about 14.5% including fees.

Going forward, this type of private investment will be a priority for us. We hope to populate the portfolio with 2008 vintage investments that offer low leverage multiples, attractive yields, and broad diversification.

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 December 31st, 2007, investment income totaled $9.0 million and net expenses totaled $4.3 million. Net management fees totaled $1.9 million including our performance-based incentive fee.

General and other administrative expenses totaled 1.3 million. Interest and credit facility expenses totaled 1.1 million. Accordingly, net investment income was 4.7 million or $0.23 per share.

Our base management fee was 1.75% on assets for the quarter end, and is presented in our statement of operations as a 2% gross fee minus 25 basis point of a fee waiver.

Our overall debt portfolio has a weighted average yield of 10.4%, up from 10.1% last quarter. The lower risk first lien secured debt portfolio yielded 7.2% and the core debt portfolio of second line secured and subordinated debt yielded 12.8%.

On December 31st 2007, our portfolio consisted of 38 companies, and was invested 21% in subordinated debt, 33% in second lien secured debt, 2% in equity investment, and 44% in senior secured loans.

Our core portfolio has 12 companies, with an average investment size of $16.1 million, and our first lien secure debt portfolio has 28 companies with an average investment size of $5.3 million.

As of December 31st, our net asset value per share was $12.07, down from $12.83 last quarter. This decline was primarily due to unrealized depreciation coming from the overall correction in the leveraged finance markets.

As a reminder, our entire portfolio is mark-to market by our board of directors each quarter using independent broker/dealer market quotations or is fair-valued with the assistance of independent valuation firms.

Now, let me turn the call back to Art.

Thanks, Aviv.

In summary, we continue to like our long term opportunity. We have high quality companies in our core portfolio, and have plenty of liquidity to have more investments at the most attractive risk reward we have seen in years.

We have the unique opportunity to invest over 80% of our portfolio in core assets, and we are originating it after the start of the market correction this summer. We have already been taking advantage of this correction, and still have over 60% of our total liquidity available to take advantage of the 2008 and 2009 vintage deals.

Due to our strong sourcing network and client relationships, we are seeing strong deal flow. That said, we remain steadfast to our investment discipline and will reiterate that quarter to quarter, you should expect us to have both periods of relative inactivity and periods in which we will invest more actively.

We will continue to focus on creating a portfolio of primarily debt instruments with an allocation to equity co-investments. Our priority is on companies that generate strong free cash flow. The goal is to capture that free cash flow primarily in debt instruments, translate that cash flow to our shareholders through a growing dividend stream.

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 continued investment and confidence in us.

That concludes our remarks. At this time, I would like to open up the call for questions.

(Operator Instructions).

Thank you, we will now take questions from the telephone lines. (Operator Instructions).

The first question is from Carl Drake of SunTrust Robinson. Please go ahead.

Good morning.

Art, I was wondering if you could talk about, given the decline in LIBOR, imagine the plan is to increase the fixed rate portion of the portfolio in the core mezzanine product, and use your lower cost floating rate funding facility to do that, but are there any -- is there any lag benefits that you might have in the interim or are they any LIBOR floors perhaps in some of the assets that you have?

Yes, the biggest benefit that you have from LIBOR, and there are some negatives, obviously, because yields are coming down from our standpoint to our LIBOR floating instruments, the biggest benefit is on the underlying credits.

Clearly, the underlying credits will have even more cushion in terms of their interest coverage as a result of LIBOR coming down. Clearly, we had a big benefit from the standpoint of our LIBOR floating rate credit facility at LIBOR +100. And as we lay in to our core mezzanine fixed rate mission, 14%-15% yields, that will be very accretive to shareholders, hopefully, more than offsetting any decline that we have coming from LIBOR going down.

But there are not many LIBOR floors in any of the floats --?

No.

Okay. A second question, could you touch on a couple of companies in the portfolio that have had probably a little bit more weakness in price like Swift and Realogy, a little bit of an update there.

Yeah, I mean, there is not really update since last quarter in terms of the performance of those companies. Swift did have a conference call for investors a couple of weeks ago, and the numbers were coming in kind of exactly as we thought they would and where they come in the prior quarter. So we do not see, the numbers actually came in better than folks expected, and they did spend a chunk of the time talking about all the initiatives that they're doing to maintain healthy interest coverage and have covered certainly well above their covenants.

So we still do not believe that there is default risk in that particular name.

How about Realogy?

Realogy has nothing new that has been reported really since the last quarter that has materially again, we don't see the way the capital structure is setup, any default risk.

So you plan to hold all these -- both Swift and Realogy to maturity?

Right, at this point, given the risk rewards, it would make not sense for us to sell. And we think they are trading at very attractive levels from the standpoint of buyers and over time, the cash flow will (inaudible) to the benefit and we will be getting paid a very healthy interested coupon on those names.

Are there any in the first lien portfolio that are concerning or is that primarily mark-to-market issues?

Yeah, they are primarily mark-to-market issues as we have said in the prepared comments, we don't see any defaults.

Okay, thanks.

Thank you.

Thank you, the next question is from Sanjay Sakhrani of KBW. Please go ahead.

Thank you.

A few model questions and then one sort of high level question.

Just going forward, should we assume that you utilized the leverage first and then think about liquidating the senior debt portfolio? One, two is on the G&A expense line, it is slightly higher than the run rate I would have thought, so I was just wondering if you could provide some color on that, and maybe just some sense on the investment page on a go-forward basis, and then I'll ask the high level question.

Yeah, so using leverage versus selling that first lien, you are correct, I mean, at this point, given where some of this first lien paper is trading, as value investors, it would not make sense for us to be selling that. So, you know, clearly, we are going to draw down on the credit facility first as we deploy and execute the mezzanine business plan.

And then in a few quarters, as we kind of get more towards fully-funded on the loan side, max implement of our loan, we'll have a decision to make. Do we sell down some of that first lien and use those proceeds to get into the core mezz, do we raise capital another way?

But that's a few quarters off and frankly, where the loans are being quoted, it is already kind of in the NAV, it's really just a question of do we crystallize those losses or not or does the market come back?

In terms of the G&A, we are working hard to keep it low. It's a new company and we are getting more and more efficient every day. So Aviv and myself and others around here are working hard to more efficiently get G&A down.

I'm sorry. Do you think it would be around this run rate on -- for the rest of the year?

Yes.

Okay.

The third part of your question, Sanjay?

Oh, just on the investment, I guess you mentioned the investment that you've had a few quarters down and you think about the senior debt portfolios, that sort of answers that question.

I'm sorry, go ahead.

I was just going say, we're myopically focused on our main mission. It's about a few good mezzanine deals, one, two, three good mezzanine deals each quarter, populate the portfolio with those 14%, 15% fixed rate yields. Draw down the credit facility to fund those and life our heads up in a few quarters. You'll see where the senior loan market is trading, where our particular paper is trading, where our stock is trading, where BDCs are trading, and then we'll have a decision to make at that point, whether to sell down the first lien or look for other capital at that point.

Okay, fair enough.

And then just -- maybe, just the high level question is maybe you could share with us your thoughts on sort of the current state of the credit markets. And, you know, what do you think the -- what gets the engine going, you know what I mean, and provide some firmness to the bids --

Yeah, yeah.

Yeah, it's a great question. It's, you know, the question, you know, I've been getting is, are we at that capitulation phase right now? And certainly it feels like we are in a capitulation phase.

The senior loan market for now and new deal appears to be pretty shut. And maybe that's what we need before we find a bottom end and we start moving back up.

But with the news yesterday was Warren Buffet offering to backstop some insurance with Bill Miller coming in saying he's against the Countrywide deal and Countrywide selling too cheap. It feels like there's a lot of capitulation. Also, it feels like some deep-value investors are starting to come in.

So, it's unclear. We're not great prognosticators. You wouldn't look to us to say that we know really where this is all going to bottom out. We're just again focused on a few good mezzanine deals, executing the plan, and we've got ample room to do that for a while and in a few quarters we'll take a look at those results.

Okay, great.

Thank you very much.

Okay.

Thank you. The next question is from Dan Furtado of Jefferies & Company.

Please go ahead.

Good morning, guys.

Hey.

I was looking at -- your pick is relatively low at $500,000 in the quarter. But can you give me an estimate of what you think it would have been if all loans that have pick options had exercised those options to pick?

I would imagine it'd probably just be a few hundred thousand dollars more. That's me, off the cuff, we can get back to you.

No I'm just looking for kind of general. So, a couple of hundred thousand more is what you're thinking?

Yes.

Okay, perfect.

And it also right now, just so I understand correctly, you're saying that the mezzanine portion of the stack is what you view as the most attractive in the current environment?

Well, look, there's great risk reward out there, period.

I mean the first-lien market is a wonderful risk reward which is why we're not selling those securities in our balance sheet right now as we're kind of -- again, to refresh your memory, our first-lien portfolio is a residual of the IPO we needed to buy that to [share them] to shareholders out of the gates. So, if we're not selling, that also implies that we might be a buyer as well. BDCs are not well set up to do it given the leverage constraints that BDCs have and also given absolute yield constraints that BDCs have.

First-lien risk reward right now is 8% to 10% type of yield in general in this market and for first-lien secured debt on some really nice companies. That is a very good risk reward. But as far as BDCs have been looking for higher yields and higher rewarding investments.

So that's why we're focused on our main mission which is mezz which we've defined from Day 1. And, you know, those are 14%, 15% yields right now plus some fees, plus some equity co-invest. And those are -- we think those are very attractive too.

And probably the most attractive thing about the current mezz market is the leverage levels are lower. The most leverage we're seeing on scenarios right now is kind of 5-ish times leverage versus a market that was at 6 and sometimes 7 times leverage in the old days.

So, you know, you can finance companies at 4 to 5 times leverage, get an all-in return at the mid to upper teens plus some equity, that's some pretty good risk reward. I'm pretty excited about that.

Excellent. Thank you for the clarity.

Thank you.

Thank you. The next question is from Jim Ballan of Bear Sterns. Please go ahead.

Hey, Art. Can you hear me?

Yup.

Okay, great

You've talked about drawing on your line of credit. And with the decreases we've seen in NAV, because of the unrealized losses. What are you thinking about in terms of remaining availability on your line and given that you've just started your view and that the first lien trip could recover, where do you think you could bring your leverage to at this point? Have you changed that view at all?

Well, and that's a great question and it's really a question of how do we view the first lien portfolio. We could turn around tomorrow and sell it and generate liquidity. As of December 31 we could have generated about $150 million of liquidity from selling that portfolio to go into mezz deals. And it's really a debate of as to whether those are more longer term investments or not.

And again it's too early to answer that question. I mean let's talk in two or three quarters as we execute the plan on the mezz side, draw down the credit facility, watch where the leverage loan market is and we'll figure it out at that point in time.

And it'll be a question of alternative use. Is it better to crystallize the loss and sell something at [90] or wherever it is and deploy that to 15% mezz? Is it better to hold on to it? What's the best risk reward for our shareholders?

And that's a non-answered answer, I realize that but I'm punting, but I think that's the only thing you can do right now given the turmoil that's going on in the first lien market.

That's fine.

Let me ask a different question then. The -- I guess it was $4.4 million of sort of sales of repayments that came back to you. Can you talk at all about just the -- how much capital do you think you'll be getting sort of just turnover of the portfolio whether it's amortizations or repayments over the next couple of quarters. And does that give you a meaningful source of cash for you?

Yeah, I mean I think of the $4 million maybe $500,000 or $600,000 was amortization.

There was an interesting email that came across my email last night which I thought was maybe indicative. It's along the lines of my comments about some of the value investors that are coming in.

We got an email on a deal. I can't disclose what it is. It's a deal in our first lien portfolio where the email said that the sponsor, the financial sponsor was coming to the first lien lenders for an amendment to permit the sponsor to come in and buy the first lien bank debt back.

So, basically the sponsor coming in and tendering for the loan because they think it's trading at a ridiculously cheap price.

And that's just, you'll see more of that. I'm not saying we're going to sell it at a severe discount. I'm saying some of the bottom fishers are coming in and starting to see the really attractive risk reward here, in this case, the sponsor coming in and then going to be making an offer to buy the first lien.

So from an amortization standpoint to your specific question, I think it was $600,000 last quarter. The other $3.5 million was small positions that we had that we could sell in the mid to upper 90s and we didn't have to follow them anymore.

Okay, great. Thanks a lot, Art.

Thank you.

Thank you.

The next question is from [Brian Laird], a private investor. Please go ahead.

Yeah, hi.

I wanted to ask you a question with regard to recovery rate on defaulted debt that, in this kind of situation I know that The Stern School of Business just came out with a report that said that on senior secured loans, the recovery rate was $0.87 on $1, while senior unsecured was $0.47 on $1, which seems like a fairly wide gap in that kind of situation. And I was wondering, given the situation we are in where we seem to be heading into a recession, if it wouldn't be wiser to invest more in senior secured loans especially also given the situation where a lot of analysts had been rating some of your competitors like Aries Capital which has a fairly large senior secured position.

I was wondering if it wouldn't be better -- rating them like a buy, and other competitors like Apollo, lower rated, where they're getting neutral ratings because they have more subordinate debt, it wouldn't be wiser actually to hold onto your senior secured position and have more of that as opposed to the mezzanine debt?

Well, okay, you're making a lot of good points in your comments and they're very appreciated.

And look, there's good risk reward up and down the capital structure, both in the senior secured and in the subordinated and you just have to ferret it out and try to pick the right deals, and hopefully, the shareholders are relying on us to help pick the right deals and whether it'd be senior secured or subordinated risk reward.

I mean we've now analyzed all the deals in our portfolio to the nth degree, we feel comfortable with them. We feel like they do represent good value.

In your remarks you made some good points which is maybe on the first lien side in particular, the selling has been overdone relative to the $ 0.87 in terms of defaulting. If you say the average portfolio today is in the, 87 to 90 range, that's assuming every deal on every portfolio is going to default which is probably not going to happen unless we have a depression.

So again that points to the fact that there's really good value out there right now in the current market.

I don't know if I answered your question or --

Basically, what I'm asking is that if senior secured is so cheap to begin with and you're in a situation where the recovery rate is just much better and it's much safer and analysts are actually rating BDCs that have more senior secured getting better ratings, why go into mezzanine debt in this situation?

It's all, generally BDCs -- okay, and I can speak for ourselves, I can't speak for others. But generally, BDCs want an ROE that's well into double digits.

Yeah.

And because BDCs have leverage constraints of one-to-one and because senior secured debt is trading at an 8% to 10% yield right now, the math doesn't work if you're just buying just first lien debt of that --

The other question I wanted to ask is your expenses are tied to the yield on the portfolio in some respect in that you get above what, 8% or 7% or 8% you get 20% of yield.

I mean, in a sense, doesn't that incentivize you to take on more risk yield-wise and go into mezzanine debt because your fees are based on the yield of the portfolio?

Well it's also based on assets. You could say under that area that we are incentivized to take all of our money and throw it into the market just to get fully invested so our management fees are higher.

Yeah.

And certainly, there were some investors, by the way, who six months ago, were suggesting that we do that that, that we aggressively ramp the dividend. And we said no, we got the investors, we do one deal at a time, we're not a production shop and we're going to take our time. And the market is difficult and we're just going to really deploy in a very judicious fashion.

So, look, ultimately shareholders are relying on us to develop a good long term track record and that's what we're focused on doing.

But thank you very much for your questions.

I have one other question is I'm wondering if would you guys, if your portfolios continue to trade at a deep discount, consider a share buyback like American Capital Strategies has just announced?

The stock we think is cheap and that's why we, as management, have been buying the stock when we can when we're allowed to. We've been personally buying stock. But when we see the mezz market so attractive right now, we think on behalf of shareholders, there are some great risk reward out there and we don't want to reduce our liquidity and dry powder from taking advantage of that opportunity.

And then one other thing. What percentage of the portfolio is mark-to-market right now versus fair value?

It's probably roughly 80-ish%.

Okay. Alright, thank you.

Thank you very much for your questions.

Thank you.

The next question is from [John Philmare] of SDR Capital.

Please go ahead.

Hi, Art. How are you? Thank you for taking my question.

Yes.

We talked a lot about coupon in terms of the mezz market which is clearly your continued focus. But can you also talk a little bit more about the covenants and protections that you're seeing in the market today that you may not have seen as much as three months ago?

Yeah. We're seeing -- that's a great question. We're seeing much better covenant protection. For mezz, we're seeing a much better covenant protection on the first lien. We're now getting full (inaudible) of maintenance tests every quarter. They're set at tighter levels. They generally ensure deleveraging.

So we're real excited by that. We're excited by the lower leverage. We're excited by the tighter, more fulsome (inaudible) covenants. We're excited about the better yields. But there's no issue with getting covenants right now.

Okay.

And then with regards to sort of your outlook and sense of the market, and your comments that the senior secured portion of the capital structure on transactions seems to be a little bit more sensitive part to getting transactions done. Are you finding that the opportunity is more on the primary side or more on the secondary side with regards to where some mezz debt may be trading currently given sort of the lack of availability or velocity of new deals being created?

Yeah. I mean, just to comment on that. We're not -- certainly the middle-market M&A deal flow is less than it was. We're still seeing plenty of deal flow for what we want to do for our vehicles so there's no shortage of opportunities.

There is the risk reward in the secondary side, no question about it. And we think there's also great risk reward in the primary side.

We already think we're fairly weighted toward secondary and we've been doing a bunch of that and we think attractive prices. So our mission is to more balance this portfolio with primary self-originated mezzanine deals that kind of balance this portfolio out. But we think there's some opportunity to the secondary side. You just got to be careful at the secondary side because there were deals that were structured in the old days, the leverage levels are generally higher and the covenant protection is generally less.

So you better love it for other reasons if you're going to buy it. One of the reasons you'll love it is because you're buying it at pretty significant discount. But you better love it and you better feel like it can handle the leverage.

The new deals that we're seeing as I said a moment ago have far less leverage on them than the old deals. That gives us a lot of comfort.

Great.

Thank you so much for my questions.

Thank you.

Thank you.

There are no further questions registered at this time.

I'll now turn it back to Mr. Penn.

Great.

I just want to thank everybody on behalf of Aviv and myself and everybody on the PennantPark team, thank you for your interest, and we look forward to talking to you next quarter.

Take care.

Thank you.

The conference has now ended. Please disconnect your lines at this time, and thank you for your participation.