Pennantpark Investment Corp (PNNT) 2010 Q4 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the PennantPark Investment Corporation earnings release of fiscal year ended 2010 results conference call. Please note this call is being recorded. It is now my pleasure to turn the conference over to Mr. Art Penn, Chief Executive Officer of PennantPark. Please go ahead, sir.

Thank you and good morning, everyone. I'd like to welcome you to our fourth fiscal quarter 2010 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 Investment Corporation 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.

I would 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 add that you refer to our most recent filings with the SEC for important tax -- 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.

Thank you, Aviv. I'm going to spend a few minutes discussing current market conditions, followed by discussion of investment activity, the portfolio, our overall strategy, and then open up it up for Q&A. As you all know the economic signals have been mixed with many economists expecting a flat to slightly growing economy going forward.

With regard to the more liquid capital markets and in particular, the leverage loan and high yield markets, the substantial rally that we saw in 2009 continued in the early part of 2010, but went through a period of retrenchment and consolidation in the middle part of the year. Over the last several months though, the high yield and leverage loan markets have strengthened as investors have concluded that a flat to slightly growing economy is well suited to this asset class. As credit investors a flat economic environment can be fine as long as our companies are appropriately capitalized.

We remain focused on long term value and making investments that perform well over several years. We continue to set a high bar in terms of our investment parameters and remain cautious and selective about which investments we add to our portfolio. Our focus continues to be on companies or structures that are more defensive, have low leverage, strong covenants and high returns. As prior cycles have proven, our new investments in this environment may end up being some of our best. We significantly reduced competition in the middle market. We are taking advantage of the 2010 vintage and are well positioned to capitalize on the 2011 vintage.

As credit investors, one of our primary goals is preservation of capital. If we preserve capital, usually the upside takes care of itself. As a business, one of our primary goals is building long-term trust. Our focus is on building long term trust with our portfolio companies, management teams, financial sponsors, intermediaries, our lenders and, of course, our shareholders. Since our inception almost four years ago, we've become 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 have become a trusted financing partner for our clients.

As the market has gotten more active, we are completing more transactions for well regarded financial sponsors with whom we've had long term relationships. We have been active and are well positioned. For the quarter ended September 30, 2010, we invested about $96 million with an average yield on debt of 17% and expected IRRs generally ranging from 13% to 18%. Our normalized yield this past quarter was around 14%. One of our investments came with free equity attached, which we valued and subtracted from the face amount of the debt we purchased. Average debt to EBITDA of new investments was below 4 times.

We expect to continue to find investments with attractive risk reward characteristics in this environment to grow our income. Net investment income was $0.27 per share. This reflects our issuance of shares during the quarter, while our run rate net investment income is higher than $0.27 per share. We have continued to be active since quarter end with a goal of growing income. As a result of initiatives to focus on high quality new investments, solid performance of existing investments 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 healthy 2.8 times. This provides significant cushion to provide stable investment income. Additionally, at cost, the ratio of debt to EBITDA on the overall portfolio was 4.6 times, another indication of prudent risk in the portfolio. The structure of investments in our portfolio is relatively low risk. It consists primarily of cash paid debt instruments and only 7% of the portfolio is preferred and common equity.

There were no new nonaccruals this last quarter. Out of 96 investments we have made since inception, nearly four years ago, we have had only three companies on nonaccrual, all of which have been reorganized. The statistics we have mentioned relating to interest coverage and EBITDA multiples, highlight an important point about the vintage of our investments. At cost, about 93% of our current core investments were made after June 2007 when the credit market started to deteriorate. As a result, the investments completed after June 2007 tend to be in more defensive sectors, at lower leverage multiples, tighter covenants, and better pricing. To date, our investment thesis on those companies remains generally on track. We are pleased with the performance of the portfolio through the stress test of the last couple of years. During the recession, on a weighted average basis based on cost, the EBITDA of the core portfolio was down only 7.2% from initial investment to its lowest point. Today with the economy improving the EBITDA numbers up from initial investment.

We are in good shape from the standpoint of liquidity. As of September 30, we had about $69 million of credit facility and cash available to us. Additionally, we have over $100 million of relatively liquid assets with coupons of 9% or less that can be rotated into higher yielding new investments which could significantly enhance our income. Last quarter we sold or were repaid on about $59 million of these sub-optimal assets at attractive prices. We have started operating our SBIC and are accessing debt from the SBA. Aviv, will go into the details shortly.

We had several realizations last quarter, most of these investments we made in the 2009 time period, and were either investments we made in the secondary market at sizable discounts to par, or were attractive financings related to restructurings. We sold our position in 1-800-CONTACTS and realized an IRR of 23%. Our loan to US Xpress was exited and generated an IRR of 46%. The exit facility related to the restructuring of World Color Press was refinanced and our IRR on that loan was 23%.

We continue to be focused on being matched from the standpoint of fixed and floating interest rates. 25% of the portfolio has as interest rate that floats, another 26% floats but has the benefit of a floor which protects income in this type of low base rate environment, and the remaining 49% is fixed rate. In terms of new investments, we had an active quarter, investing in attractive risk adjusted returns. Our activity was driven by a mixture of M&A deals, refinancings and gross financings, in virtually all of the investments we have known these particular companies for a while, have studied the industries, have a strong relationship with a sponsor or have proprietary information flow. Let's walk through some of the highlights.

We invested $10 million in senior notes of Affinion, which is a leading affinity marketer sponsored by Apollo. Airvana is a provider of network infrastructure software products used by wireless operators. We invested $15 million in a first lien tier secured loan, SAC Private Capital controls the Company. We purchased $18 million of a first lien senior secured loan of K2 Pure Solutions. K2 is a manufacturer of chemicals, sponsored by Center Partners. MedQuist provides medical transcription software technology and services to healthcare organizations, we purchased $18 million of subordinated debt. We invested $8 million in a combination of first lien debt, subordinated debt and equity in SuttonPark Holdings to back a management team in the structured settlement industry. Three Rivers Pharmaceuticals is a specialty drug manufacturer focused on products for hepatitis C among other areas. We invested $24 million in first lien senior secured debt and equity to back the purchase of the Company by Kadmon Holdings.

Turning to the outlook, we have continued to see activity levels pick up. We are seeing a rise in the level of middle market M&A, which over time should drive a substantial portion of our investment activity. Much of our business will be driven by companies that need a financing solution and don't have many options as finance companies, CLOs and local banks have exited the market. Due to our strong sourcing network and client relationships, we are seeing tremendous 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 September 30, 2010, investment income totaled $16.7 million and expenses totaled $7.7 million. Management fees totaled $5.5 million. General and administrative expenses totaled approximately $1.1 million. Interest and credit facility expenses totaled about $1.1 million. Accordingly, net investment income was $9 million or $0.27 per share. During the quarter ended September 30, net unrealized change from investment was again up $3.2 million or $0.09 per share. Net realized gain was $1.2 million or $0.04 per share. Unrealized change from credit facility was a loss of $6.8 million or $0.20 per share. Excess dividend over net investment income was approximately $400,000 or $0.01 per share and the dilutive effect of the issuance of new shares was $0.17 per share. Consequently, NAV per share went from $10.94 to $10.69 per share.

As a reminder, our entire portfolio and our credit facility are mark to market by our Board of Directors each quarter using the exit price provided by an independent valuation firm or independent broke-dealer, quotations, when active markets are available under ASC A20 and ASC A25. In cases where broker-dealer quotes are inactive we use independent valuation firms to value the investments.

Our overall debt portfolio has a weighted average yield of 12.7%, up substantially from 11.9% last quarter. On September 30, our portfolio consisted of 43 companies and was invested 35% in senior secured debt, 24% in second lien secure debt. 34% in subordinated debt and 7% in preferred and common equity.

Our SBIC is making progress, as of September 30, we had committed $50 million of equity to the SBIC and subsequently received a debt commitment from the SBA of $100 million. At quarter end, we had invested about $15 million of equity and drawn the same amount on SBIC debt. Subsequent to quarter end, we continued to invest in the SBIC and completed our SBA examination in order to gain access to the full SBA commitment of $100 million.

With regard to the dividend, as of September 30, our run rate net investment income, assuming no changes, continues to be greater than our dividend. As you know DDCs are obligated to pay out at least 90% of their net investment income. If we make no new investments and our portfolio continues to perform, our income will continue to be higher than our dividend. Now let me turn the call back to Art.

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is a steady, stable and growing dividend stream. Everything we do is aligned to that goal. We try to find larger less risky middle market companies that have high free cash flow conversion. We capture that free cash flow primarily in debt instruments. 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 continued investment and confidence in us. That concludes our remarks. At this time, I would like to open up the call to questions.

Thank you.

(Operator Instructions) Our first question comes from John Hecht with JMP Securities.

Good morning, guys, thanks for taking my question. And congratulations on a good quarter. First question, Art, you suggested that there was a broad source of the deals this quarter from supporting privatization as well as supporting some maybe, expansion or acquisition type loans. Excuse the sirens, by the way, I'm on the road. I'm wondering, you seem to have a pretty active pipeline right now. Where is that coming from and are these secular changes you're seeing that you think are going to have sustaining trends or are some of these just periodic changes in the market that give you some opportunities?

Well, on the -- thank you, John. On the supply side of the equation, a lot of the deal flow is being driven by middle market activity. Much of that being middle market M&A activity. Whether it's now after the recession, buyers and sellers can come to terms again, or whether it's people wanting to do deals before year end due to potential tax law changes on capital gains or carried interest. Those are some of the key drivers. Is it going to continue past December 31? We think it will, although we think it will probably take in some form of dip after year end, as the folks who are trying to get their deals done between now and year end get them done. We think there will be probably some sort of pause of some sort in January, February, before a more normalized activity picks up again.

Okay. And then the redeployment of the lower yielding securities in your portfolio, it sounds like, if I heard you right, you did $59 million last quarter redeployment. How much remaining of your portfolio, how much remaining would you consider to be characterized as lower than optimal yields and how long do you think it will be take to redeploy that?

Well, as we've disclosed, we have over $100 million of securities that are quoted by broker dealers, are relatively liquid, that have coupons of 9% or below. So, our intention would be to over time rotate that portfolio into new deals at higher yields.

Okay. And final question is, pretty attractive yield on the new deals. Are you seeing any pressure on margins? Or is still pretty good pricing power in the market?

Generally, pretty good pricing power in the market. Our normalized yield this quarter was around 14%. Where you've seen the greatest pricing pressure is not our end of the market but the end of the market where you have to compete with the public high yield market or the public leverage loan market which, as you know, have been on fire. We tend to stay below that radar and the competitive framework remains very attractive in that traditional middle market world that we are in.

Okay. Thanks very much for the color.

Thank you, John.

And next we'll hear from John Stilmar with SunTrust.

Good morning, guys. Real quick question. Can you put in context for me the interest coverage, I believe 2.8, you referred to this quarter where that's trended over the prior couple quarters? And, just a quick starting point.

Yes, I think it was up a little bit this quarter from like 2.5 last quarter. Kind of, over the last year it's been between, call it, 2.5 to 2.8, 2.9, that's kind of where it's been -- it's kind of fluctuated within that zone.

Okay. So, with the coupons it's actually gone up. So a pretty good sign there. And then more to John's previous question which -- with regards to competition. At the smaller end of the market, are you starting to see any banks starting to compete? I know, it seems like you've done some -- have been pretty heavily involved in unit tranche investing. It would seem like, to me, that banks would be the only real primary competition there at least in taking the first part of the unit tranche asset class. Have you seen banks start to become more aggressive, in which making the unit tranche asset a little bit more competitively priced?

It's a great question. Though, it's interesting. There is a handful of banks who are in this middle market leverage finance world and the competitive framework hasn't really changed that much over the course of the last year or two. It's the same handful of people that you see time and time again. In these middle market buyout deals. Every once in awhile you'll see a regional or local bank who has a particular axe to grind in a region. But, we're pretty -- feel pretty good about the competitive framework. There is -- about half of what we do is a traditional first lien mezz, where we'll be the mezz and about half of what we've been doing is more, we're the stretch senior piece. We love to be the first dollar in if we can and get nice returns, but in some cases with the handful of people who are traditional first lien lenders and a mezz piece, that can be more efficient, more efficient cap structure for a sponsor.

Okay. And then my last question, with regards to the emerging SBIC facility, and very prudently deploying capital there, can you tell me how the structure of that facility works with regards to your underwriting process? For instance, are you -- when you are looking at products are you looking at products that might be a little bit different or more core to what you've traditionally looked at by virtue of the fact that you now have an SBIC? Has there been any changes in the types of things that you're starting to look at and if so, could you share how those changes might have evolved?

That's a great question. The only -- we have not changed our style or shifted our style at all due to the SBIC. That was one of our key diligence items as we investigated whether to get an SBIC license would be, which deals in our existing portfolio would fit into an SBIC. And we found -- when we did the work we found that 70% or 80% of our existing portfolio would fit under the SBIC guidelines. So that's one of the things that got us comfortable. So, basically what it is we are originating and doing the same deals that we were doing before and if they fit the SBIC, they are going to go into the SBIC first.

Great. All right, well, thank you, guys. Congratulations.

Our next question comes from Sanjay Sakhrani with KBW.

Hi, this is actually Steven Groth filling in for Sanjay. Thanks for taking my question. I guess, just to follow up on the SBIC facility, you had mentioned that it would be the first to be deployed. I guess on the credit facility front, I know the maturity isn't due until June 2012. But has there been any talks ongoing with your creditors on perhaps renewing the facility?

That's a great question and we are starting to think about all the different options that we have for debt going forward in the long run. Obviously, the existing credit facility matures in 18 months so, we're going to explore all the different methodologies of debt as we go forth here, whether it be more SBIC financing. Obviously, were going to try to maximize that. We're going to look at bonds and there has been some examples of bonds that have been done in the BDC industry recently, we're going to investigate securitization technology. So we're going to look at all of the different tools and probably, over the long run, have a combination of tools and have a diversity of funding sources.

Great. Thanks for taking the question.

Thank you.

(Operator Instructions)

Next we'll take a question from Troy Ward with Stifel Nicolaus.

Great. Thank you. Just a quick question to follow up on the SBIC. Art, your path to the SBIC was much quicker than most and I saw you already have the $100 million commitment. Can you just walk us through what you need to do to take that up to $150 million? And then for a longer term question, as we think about modeling this several years down the road, what do you need to do to eventually get that to $225 million and what will the timing on that look like?

Aviv will take that one.

Just with respect to the $100 million we are taking maybe up to $150 million. But in steps, so, we have committed $50 million, and the SBA matched it times 2 to $100 million. Once we deploy that and feel comfortable, we'll take the extra -- we'll commit an extra $25 million and the SBA will match it times 2, again. By $50 million, so we'll be fully to -- up to $150 million. So, we feel comfortable that we are well on our way. We have completed the audit as we disclosed, and once we get the final stamp of approval, very soon from the audit, we feel that we can really go to the full fledged depending on the deal base.

From a paper -- from a standpoint to go up to $225 million with a second license, how long does it usually take to get the second license, and can you start that process before you max out your $150 million?

Our understanding is that once you do the $150 million or get close to the $150 million, you start thinking about upping it and you essentially need to create a second vehicle, again. The SBA will not lend to one manager, PennantPark, more than $225 million. But to one SBA no more than $150 million. You need to really create a second vehicle, which we can obviously look at as we get to closer to maximizing that bucket.

Okay, great. Thanks. And then, Aviv, can you talk a little bit -- the other income line was a bit convoluted this quarter. Can you talk about what would cause that and then what kind of fees were you seeing on the deals that were closed in the quarter?

Right. So, the other income is specifically there to show that these are nonrecurring. So, some months it will be a small positive, some months it will be a negative, a small negative. I think this month we had a K-1 that was received from one of our equity positions. Once a year we get the K-1s. It showed a negative, I believe, of $300,000 or so. So transportation $100,000 was the security. Without that, I think the net income, or that line item, would have been a small positive or near zero. Again, it's hard to project what this line item -- again the purpose of this line item is if we get an amendment fee, a one time amendment fee, or some type of nonrecurring income, we'll put it in that line item to highlight that it's not recurring.

With respect to the new deal fees, we're still seeing 2% to 3% upfront fees typically in deals. What we do book for GAAP and for tax every chance we get, is we amortize those over the life of the loan. So, we're very focused on being matched from a GAAP and a tax standpoint. So, there's virtually no difference from the standpoint of our books between GAAP and tax and we amortize those fees over the life of the loan.

Okay. Great. And then one last question about the new deals. I know in the past you've done a combination of buying a piece of somebody else's larger deal, clubbing in with others verses you're the lead structure where you're taking a majority of the particular tranche or the slice of mezz. Can you talk about the deals you saw this -- that you closed this quarter, how those looked, whether you were part of a larger club or whether they were your proprietary deal?

Yes. It's a great question and again it's usually a mixture of the two. Currently, about half of our portfolio is broker-dealer quoted. Obviously, there's various levels of liquidity, when you get a broker-dealer quote. Some are extremely liquid, some are liquid but if you had to exit would take a week or two or three to get out of. And sometimes we're brought in -- sometimes we get the call from a syndicator saying, help, the deal is in trouble. We need someone who can dig in and roll up their sleeves, understand the credit and negotiate the covenants and we are happy to get those deals. We want to get those calls.

I would say, of the five deals that we did this quarter, I'm just taking a look here. Two were purely syndicated liquid deals. One was where the deal ran into problems and we got the call for help and we went in and, some very well-known other investors followed our lead when we dove in and did our diligence and restructured the deal. And two were purely originated deals where we were the lead from the get-go. So, a combination and, look, we want to see the wide range of deal flow and opportunity. We like having some liquid assets in our portfolio. And we want to be able to cherry pick the best rich reward that's out there whether its illiquid, liquid, or some hybrid between the two. I don't know if I answered your question, Troy, but--.

Yes, you did. Thanks, guys.

Our next question will come from Jim Stone with PSK Advisors.

Thank you for the nice quarter, gentlemen.

Thank you.

Trying to get a better understanding of the new items you added. You said on average they're 17% and my first reaction to something that high would be that there's a problem with it. So, could you give us some--?

Color? Yes. That's a great question, and the normalized is 14%. We have one deal where we got free equity. And to us, when we make a loan we get free equity, to us first and foremost, we want to make sure the loan's good. and the equity upside is just gravy. With the BBC and with the mark to market vehicle, we are obligated to value that equity, value that free equity then deduct it from the cost, which therefore means, the yield -- the effective yield goes up. So, when you normalize that out, it's a 14% quarter, which is in line with our past.

Okay. Thank you very much.

Thank you.

Our next question comes from Ram Shanker with FBR Capital Markets.

Good morning, gentlemen. Thanks for taking my question. Nice quarter.

Thank you.

Just, sorry to go back to the SBIC, but just looking at the criteria for deals that can be funded by the SBIC, net worth of these businesses have to be less than $20 million or so. Can you maybe just define the size of the market and how soon you can ramp that up?

A good question. As we are going along here, at least half of what we are looking at is applicable to the SBIC. Some of it isn't. Sometimes you have a US headquarter company but the manufacturing's done in some other country which doesn't really fit the spirit of what the SBA wants us to do. So we have to be careful and look at ourselves in the mirror as we're doing these deals. But at least half of what we're looking at does fit very well and, again, we're very active. So can't give you a real kind of, we're going to be fully ramping the SBIC by time X. But, we're -- we've been fairly active utilizing the capital.

Okay. Just in terms of booking the deal, is there a [refro] typically involved, and do you have to show it to the SBA before you put in the SBIC subsidy each time? Can you just kind of walk us through the process?

At this point the answer is no, we do not need to show it to the SBA pre-funding. Obviously, everything we are doing has paperwork with the government, so we file a bunch of -- we inform them, obviously, of what we have done. Post the investment and they are looking at it very carefully and examining it. Remember, that they are asking us for quarterly information or semiannual information. It's all very regimented, as well as, annual exam as we said, we just completed our first annual exam. So we are -- with zero funding. So there is a whole process around it, but no, we don't need to ask for permission if we put two more on new deal into the SBA, other than just reporting subsequently.

Okay. Thanks for taking my question. Congratulations again.

Our next question comes from Jim Altschul with Aviation Advisory Service.

Good morning, gentlemen. A couple of questions, please. First of all, I noticed this fiscal year you had, albeit, a small income tax charge. What did that come from?

The income tax is essentially an excise tax since, as we disclosed our dividend is less than our income. In other words we do build a kitty here. We're obligated to distribute 90%, which we do, but anything that we are distributing less than 98%. So anything between 90% and 98%, is taxed at 4% which we believe is a cheap financing cost to finance the business. So this is what you see, the small -- about $100,000 or so excise taxes we paid during the year for that purpose.

Okay. Thank you. And next question, I want to return to the subject of the competitive landscape because during the last fiscal year, PennantPark issued some more equity by means of a secondary. And I'm aware of a number of well-known BDCs that have issued more equity and there have been some BDC IPOs, is there enough new cap -- additional capital in the BDC space to have a meaningful impact on the supply and demand for capital?

That's a great big picture question. Look, the middle market in the United States is vast, really vast. I think for BDCs whether they are be existing BDCs, or new BDCs, the middle market credit crunch continues. And it's the amount of capital that we BDCs can raise is not really putting a dent in that opportunity. So, we just hope that any existing BDCs and any new BDCs maintain rationality, because it's a very good supply/demand imbalance in all of our favors at this point.

Thank you very much, gentlemen.

Thank you.

(Operator Instructions)

Okay, so let's wrap it up then. Thank you, everybody for listening in today. Our next quarterly earnings report will be in early February. We look forward to speaking to you then. Thank you very much.

Thank you and this does conclude our conference. We thank you all for your participation.