Pennantpark Investment Corp (PNNT) 2017 Q2 法說會逐字稿

Good morning, and welcome to the PennantPark investment Corporation's Second Fiscal quarter 2017 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 Investment Corporation. Mr. Penn, you may begin your conference.

Thank you. And good morning, everyone. I'd like to welcome you to PennantPark Investment Corporation's Second Fiscal Quarter 2017 Earnings Conference Call. I'm joined by today Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and include a discussion of 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 broadcasts 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 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 ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at www.pennantpark.com or call us at 212-905-1000. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Thanks, Aviv. I'm going to provide an update on the business starting with financial highlights, followed by a discussion of the overall market, the overall portfolio, investment activity, the financials and then open it up for Q&A. For the quarter ended March 31, 2017, we invested $60 million at an average yield of 9.5%. Net investment income was $0.23 per share, which includes a $0.02 per share of a fee waiver. NAV was stable at $9.09 per share, down slightly from $9.11 per share on December 31. We believe that our new dividend rate of $0.18 per share is sustainable. As a result, we believe that PNNT stock should be able to provide investors with a steady dividend stream, along with potential upside as the energy market stabilizes and our equity co-invests mature. With regard to the overall market, the economic signals have been moderately positive. With regard to the more liquid capital markets, and in particular the leveraged loan and high-yield markets, during the quarter ended March 31, those markets experienced strength as high-yield and leveraged loan funds experienced inflows due to a belief in a stronger economy and a benign interest rate environment. We remain focused on long-term value and making investments that will perform well over a long period of time and can withstand different business cycles. Our focus continues to be on companies and structures that are more defensive, have low leverage, strong covenants and high returns. 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 credit providers and, of course, our shareholders. We're a first call for middle-market financial sponsors, management teams and intermediaries who want consistent credible capital. As an independent provider, free of conflicts or affiliations, we've become a trusted financing partner for our clients. Since inception, PennantPark entities have financed companies backed by 175 different financial sponsors. Our portfolio was constructed to withstand market and economic volatility. In general, our non-energy portfolio is performing well, despite a mixed domestic and global economy. We have cash interest coverage ratio of 2.4x and a debt-to-EBITDA ratio of 5.1x at cost on our cash flow loans. We are pleased that we have diversified funding sources, with several features that reduce overall risk to the company. First, we have $321 million of long-term, unsecured bonds, and only utilized about 15% of our long-term $545 million credit facility. Second, we are utilizing the expanded capacity under the new SBIC legislation. SBIC financing creates financial cushion and now we have exemptive relief from the SEC to exclude SBIC debt from our BDC asset coverage debt, and SBIC accounting's cost accounting, now mark-to-market accounting. Third, to better align the measurement of asset and liability values, for both GAAP and the BDC asset coverage debt, we mark both our assets and our liabilities to market. As a result of these features, we've provided substantial safety to our shareholders, bondholders and lenders in the event of market volatility.

Additionally, with asset yields coming down over the last several years, we're looking to create attractive risk-adjusted returns in our portfolio. We intend to focus on lower risk, primarily secured investments, thereby reducing the volatility of our earning stream. Investments secured by either our first or second lien, are about 75% of the portfolio. As part of the portfolio repositioning, we also look forward to gradually reducing the equity portion of the portfolio, which was 12% as of March 31. For example, we actually did half our position in the public equity of e.l.f. Cosmetics during the quarter as well as our equity coinvest in Service Champ. The sales of these equity positions generated $18 million of cash. Due to all these factors, we remain comfortable with our target regulatory debt-to-equity ratio of 0.6x 0.8x. On an overall basis, our net leverage, debt minus cash, is 0.84x and we are targeting overall GAAP leverage of 0.8x.

During the past year, we've had the opportunity to restructure most of our challenged energy names. Generally, post restructuring, these companies are now positioned to weather a period of prolonged, lower energy prices and should benefit from the gradually improving environment. We believe it will take us more time to maximize the recovery on the energy portfolio. Despite the Great Recession and credit crisis, PennantPark Investment Corporation has had only 12 companies go on nonaccrual out of 185 investments since inception 10 years ago. Further, we are proud that even when we have had these nonaccruals, we've been able to preserve capital for our shareholders. Through hard work, patience and judicious additional investments in capital and personnel in those companies, we've been able to find ways to add value. We constantly monitor our deals and re-underwrite them in the face of new information. In situations where the best long-term value for shareholders is created by taking control of the companies and providing capital and expertise, we do. We currently have 1 investment on nonaccrual, which represents 0.3% of the overall portfolio on a cost basis.

Based on values as of March 31, to date we have recovered about 81% of the capital invested in those 12 companies that have been on nonaccrual since inception of the firm. It might be helpful to highlight our long-term track record over 10 years, including the Great Recession. Since inception, PNNT has made 185 investments, totaling about $4.2 billion and an average yield of about 13%. Including both realized and unrealized losses, PNNT lost only about 40 basis points annually. In terms of exits, we had a solid quarter of attractive exits of Jacobs Entertainment, AP gaming, Service Champ and Roto Holdings debt. We also realized the loss on our investment in DirectBuy. In terms of new investments, our focus is on senior, oriented secured assets. In virtually all of these investments, we've known these particular companies for a while, have studied the industries, or have a strong relationship with the sponsor.

Let's walk through some of the highlights. We invested $20 million in the first lien term loan for Bottom Line Systems, which provides healthcare revenue cycle management and consulting services. Riverside Partners is the sponsor. DermaRite Industries manufactures and distributes skin care and wound care products. We [won] $10 million of first lien term loan. Tailwind Capital is the sponsor. We invested $16 million in the term loan B of 160over90 which provides consultative branding and marketing services, primarily to the higher education sector. Searchlight Capital Partners is the sponsor.

Turning to the outlook. We believe that the remainder of 2017 will be active due to growth and M&A-driven financings. Due to our strong sourcing network and client relationships, we're seeing active deal flow.

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

Thank you, Art. For the quarter ended March 31, 2017, recurring net investment income totaled $0.19 per share. In addition, we have $0.02 per share of other income and $0.02 per share from the fee waiver. As a result, net investment income for the quarter was $0.23 per share.

Looking at some of the expense categories. Management fees, after waiver totaled $8.4 million. General and administrative expenses totaled $1.6 million and interest expense totaled $7.2 million. During the quarter ended March 31, unrealized gains from investment was $20 million or $0.28 per share. We also had unrealized losses from our various debt instruments of $6 million or $0.09 per share. We had about $18 million, or $0.26 per share, of realized losses. Excess income, over dividend, was $40 million or $0.05 per share. Consequently, NAV per share went down $0.02 from $9.11 to $9.09 per share. As a reminder, our entire portfolio, credit facility and senior notes are mark-to-market by our Board of Directors each quarter, using the exit price provided by independent valuation firms, securities and exchanges, or 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 overall debt portfolio has a weighted average yield of 11.9%. On March 31, our portfolio consisted of 56 companies across 26 different industries. The portfolio was invested in 42% senior secured debt, 32% in second lien secured debt, 14% in subordinated debt and 12% in preferred and common equity. 83% of the portfolio has a floating rate.

Now let me turn the call back to Art.

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is to generate attractive risk-adjusted returns, through income, coupled with long-term 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 debt instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders.

In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. Thank you, all, for your time today and for your 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) And we'll take our first question from Matya Rothenberg of SunTrust.

You touched on this in the prepared remarks, but would say that your repayments and sales this quarter were primarily driven by your derisking initiative, or is it more of a reflection of pricing trends in the market?

It was more of just what was going on in the market. We had a very large quarter of originations, the quarter ended December. That's usually an active, active quarter, typically, and typically the first calendar quarter of the year ended March, is slow, as it was for us. And there was a fairly robust market, which meant Jacobs Entertainment, and a bunch of other deals got taken out, in some cases, with nice prepayment penalties. So that was the key driver. We kind of knew we'd have a robust December quarter. We kind of knew we'd have a more mellow March quarter.

And then your portfolio yield remained flat this quarter, despite that exit activity, were a lot of your exits were lower yielding. Can you discuss some of the drivers behind that?

Yes, some of the exits were lower-yielding. Don't really have a precise reason as to why net-net, the portfolio kind of has the same overall yield, albeit the new deals that we -- and I guess, maybe the new deals that we put on, which were 9.5% yielding deals were somewhat comparable to the deals that we exited. But we can get you more precise data later, Matya.

I was wondering if you could give us your perspective on how tax reform and the regulatory environment can affect your portfolio companies and potential origination you expect to do this year.

Look, this is not certainly our expertise. We think we know a little bit about credit in the middle market, or a lot about the credit in the middle market. We certainly are not tax experts. We would say though that, if the economy can be helped by tax reform, it would help the underlying portfolio -- companies in our portfolio, which would generate better returns for us. So anything that can help the economy, we'd be in favor of.

We'll hear next from Rick Shane of JPMorgan.

I'm curious. I mean, look, you pointed out that during the first quarter, or during the March quarter for you guys, that you generated some good repayment fees. I'm curious in the current environment, with yield terms evolving and frankly, probably, longer durations on the assets that you're going to originate now with higher rates, how you're shifting terms. Are there other features that you're adding to loans, given the current outlook?

So that's a good question, Rick. I think the most important thing for us is credit quality. We continue to be in an environment of yield compression. So for us, in this environment, we focus on credit quality first. We're willing to give up a little bit of yield to have a better credit or move a little higher in the capital structure. You saw that this quarter when we were -- it was a slow quarter, but we were relatively selective of the vast majority of what -- it was at the top of the capital structure. That was a little bit lower yield than what we normally do. And we're totally fine with that kind of focus in this particular market environment of a relatively buoyant time in the credit market. So it's essentially a seller's market these days for both companies and credit. So, for us, we just have to be very good credit pickers. We have to protect our capital, get a reasonable yield for our capital and take it slow.

Got it. And again, I think, related to that, given some of the objectives, it seems like you set out last quarter in taking down the leverage this quarter. Is this where you're comfortable in terms of what the capital structure looks like in the current environment?

Yes. So, we said, and I'll reiterate, on an overall GAAP basis, we're targeting 0.8x leverage, which we think is reasonable in this environment. Gives us a good defensive posture and gives us a good offensive posture. So that's kind of what we're targeting on an overall leverage basis.

(Operator Instructions) And next we'll hear from Jonathan Bock of Wells Fargo Securities.

Fin O'Shea in for Jonathan this morning. Just kind of to segue off Rick's commentary a bit on the spreads and valuations. If you look at a lot of your higher-yielding names. We have several names and double-digit spreads that are marked above par. Can you kind of walk us through how much that is driven by anticipated repayment and call protection or is this just kind of looking at tightening spreads and assigning premium valuations to these names?

Good question, Fin, and it's a little bit case-by-case. Valuation firms look at both absolute yields in the marketplace as well as call protection. In some cases we have very substantial call protection, which is terrific in this environment. In some cases we have less call protection, which means, as long as the credits are performing, we'll probably get taken out. And that's just the life we -- that's the life we chose when we got into the direct lending and middle market lending business. And so it's a little bit of each element. I don't have a specific percentage off the top of my head at this point. We could try to get in it with you later on today. But it's a relatively high yielding portfolio. And look, if we get paid back, which we do from time to time, we say thank you. We never begrudge a borrower's desire to pay us back, because sometimes they don't pay us back, and then -- we're appreciative when people pay us back. So it is what it is. We're going to take the opportunity to market and hopefully to get liquid on some of our equity coinvests and derisk the portfolio that way as well. Use that extra liquidity to either deleverage or put into new deals with contracted risk-adjusted returns and easily, hopefully cover our dividend, work through our energy names and have a very solid, lower-risk portfolio in this environment.

On that matter, is there -- one that should be fresh in your mind's come to mind: U.S. Well Services that was just restructured, you have that already marked up, I think. BlackRock reported last week with the same piece, but marked [at cost]. Could you maybe explain the difference there? Is that based on market valuations?

No, I mean and I think -- and we can go through it later, I think we marked it at the valuation at the time of restructuring. So we did not mark it up beyond the value at restructuring. We can go through those numbers with you later. The company is doing well. And then I think 1 of the pieces of papers is broker-dealer quoted it up higher than the value at restructuring. So hopefully that yields does pretty well over time.

Appreciate that. And 1 more company, specific one is, do you have any guidance on the equity versus your 3/31 fair value for Affinion, given that restructuring?

Yes, so, what's going on with Affinion, we have, as of 3/31, 2 pieces of debt and a piece of equity. The restructuring, basically, does a whole refinancing of the capital structure, pushes out maturities. It's going to mean that our 2 debt pieces are taken out. One will be taken out above par. And we'll have the remaining equity piece, which we're going to ride. You saw the markdown in the Affinion equity and that was due to the dilution of new capital coming in to extend the timing on this company's capital structure. We're actually very optimistic. We needed -- or the independent valuation representative needed to reduce the value of the equity, because of the dilution of the new investors coming in. But because you've taken away all the short-term maturities and you've extended the option, we still remain optimistic about the value of that equity in the long-term.

I guess just 1 more global question. Can you give us an update on your view of stock buybacks today, in the current environment? And can we -- would we be expecting any of the continuation of that program this year? And that's all from me.

Yes, so we -- look, we always -- and our board always considers stock buybacks. We did a substantial stock buyback last year. With our focus on having a less levered capital structure, a less risky capital structure and [plenty] [environment] And targeting [0.8x] overall GAAP leverage and then knowing how the rating agencies feel about rating, and about stock buybacks work. We're always considering it. We have elected not to do it here in the short run, but we're always considering it, but we're sensitive to all the other various factors.

And next, we will hear from Chris York of JMP Securities.

Just have a couple. I haven't gone through the schedule of investments yet, but it appears PIK income, accelerating meaningfully in the quarter relative to historical quarters. So could you provide some color on maybe that attribution in the increase? And then secondly, how are you looking at pricing PIK versus cash for new investments, given your changes to more senior secured loans?

Sure. So, when you're looking at a statement of cash flows and you're seeing the PIK income accelerating a little bit, you need to take it kind of for year-to-date, recall that some of the PIK income will record, let's say, semi-annually instead of quarterly, so it's not evenly distributed. So maybe March quarter end we recorded it, whereas, December quarter end we did not record it on December cash flows. But if you look at the 6-month, I think that will be safe for you to compare 6 months versus prior 6 month, and you'll see that pretty steady. There is no increase in PIK income that we have reported.

And then, Chris, second part of your question. Certainly on new investments, we are minimizing or having no PIK to the extent possible, and in terms of existing investments, some of those are some of the lower in the capital structure types of investments that we hope to get out of and exit in the not-too-distant future. So the goal, again, in line with our overall less risky portfolio is to not book new PIK deals and to get liquid at appropriate prices on existing PIK deals.

And then secondly, you had a nice quarter of originations, but I'm curious how much of your pipeline as you sit today, would you quantify would be SBIC eligible?

It's a great question, because we're always grappling with what's SBIC eligible or not. Look, we're trying, we are again -- just to reiterate, we never reduce our credit metrics just to find deals that fit the SBIC. We need to make sure, first and foremost, just like every other deal we put in our portfolio, the credit is solid, that we're not taking capital risk on those credits. Obviously, when credits do come in and they can fit the SBIC's, that's a great port of first call. We go through -- it's a lumpy business. That -- our business overall is lumpy and the SBIC business is even lumpier. We go through time periods where, for whatever reason, we're very prolific at finding deals that fit our parameters and fit the SBIC, and then there's other times when we don't. So it's great financing. We love it. We want to use it, but we don't want to reduce our credit standards.

Fair enough. Lastly, so as I look at your portfolio mix, preferred and common equity, both 12% on fair value. What is your portfolio management preference for that as a percentage of the portfolio, given your change, essentially, in your focus on senior secured loans?

Yes. So look, from day 1, we've always said that common equity bucket is targeted to be a 5% to 10% bucket. And that consists of 2 elements. One is, equity that we invested in from the get-go, which is typically equity co-invests and our track record of equity co-invest -- and maybe for next quarter, we'll actually be able to dig out that track record for everybody. Our track record on those equity co-invests is pretty solid and that has been accretive to ROE. The other kind of equity we get is where we convert debt to equity, which is the equity we don't enjoy getting, but is just part of our business. So that 5% to 10% includes both equity co-invests as well as the conversions of debt to equity, which inevitably happen in our business from time to time.

Helpful. And then, on the coinvestor not taking any more or less than you historically have, in the way that you price and position your capital?

At this point in time, we're a little bit more skeptical of the equity co-invest. We might be able to feel good about being a lender at 4x, 4.5x or even 5x debt to EBITDA. Many times we are less comfortable with being an equity coinvestor when it's a double-digit multiple of EBITDA. So we generally feel pretty good about this credit environment. We feel like the economy's in pretty good shape, the leverage multiples are relatively reasonable, particularly, in the middle market. There is a lot of private equity capital out there. The benefit of being a lender today is there's big equity slugs beneath you, and that makes you feel good. If there's a problem, the sponsor's more likely to solve it by putting some more equity in. That said, we're becoming more and more -- we're more and more reluctant to co-invest in the equity at double-digit multiples. Let's put it that way.

And from Baird, we will hear from Bryce Rowe.

Just wanted to follow up on Chris' question about PIK there. So over the first 6 months of this fiscal year, you've got a little bit over $11 million dollars of PIK income, and as you said if you kind of average that out, you're about $5.6 million per quarter. Is that kind of a good run rate from a PIK perspective to assume roughly $5.5 million to $6 million per quarter of PIK income?

I mean, you could infer that from the numbers, our goal, though, Bryce, is to reduce that number. And whether that means judiciously pruning the portfolio or exiting some of those names or figuring out how to redo those capital structures to get more cash. Our goal, just like our goal is to reduce the rest of the risk of the portfolio, our goal on the PIK side is, yes, you could assume the existing run rate is the run rate. But our goal -- and we're going to chip away at over the coming quarters is to reduce debt PIK.

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

Really appreciate everyone's time today and focus and we look forward to speaking to you in early August, which is our next quarterly conference call.

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