Pennantpark Investment Corp (PNNT) 2022 Q4 法說會逐字稿

Good afternoon, and welcome to the PennantPark Investment Corporation's Fourth Fiscal Quarter 2022 Earnings Conference Call. Today's conference is being recorded. (Operator Instructions) Thank you.

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.

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's Fourth Fiscal Quarter 2022 Earnings Conference Call.

I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, 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 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 obtain copies of our latest SEC filings, please visit our website at pennantpark.com or call us at (212) 905-1000.

At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Thanks, Rick. We're going to spend a few minutes and comment on our target market environment, provide a summary of how we fared in the quarter ended September 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, a detailed review of the financials, then open up for Q&A.

From an overall perspective in this market environment of inflation, rising interest rates, geopolitical risk and a potentially weakening economy, we are well positioned as a lender focused on capital preservation in the United States, where the floating interest rates on our loans can protect against rising interest rates and inflation. We continue to believe that our focus on the core middle market provides important attractive investment opportunities, where we are important strategic capital to our borrowers.

In times of market volatility, our opportunistic credit strategy focuses on creating value from the dislocation in the markets. Specifically, we've been active buying first lien loans in the secondary market at discounts in companies where we have differentiated institutional knowledge. It could be a company that we used to finance in a sector where we have domain expertise or a direct relationship with the management team or financial sponsor. We've been buying loans where we think we can generate double-digit or low teens IRRs as the loans return to par in 3 years. We employed a similar strategy during the global financial crisis and generated excellent returns.

In prior quarters, we outlined a game plan for growth of net investment income and dividends. We continue to execute on our plan to increase long-term shareholder value, and I'm pleased to announce that the Board of Directors has approved another increase of our quarterly dividend of $0.165 per share payable on January 3 to shareholders of record as of December 19.

Additionally, during the September quarter end, we continued buying shares under our stock buyback program and purchased approximately 189,000 shares during the quarter for $1.2 million. In total, we have bought back $13.2 million of shares or 1.8 million shares.

Some highlights for the quarter ended September 30 were as follows: our debt portfolio continues to benefit from rising base rates. Our weighted average yield to maturity increased to 10.8% from 9.3% last quarter. Approximately 96% of our assets are floating rate compared to 47% of our liabilities that are fixed rate. Holding everything else constant, every 100 basis point increase in base rates translates into approximately $0.02 per share of NII.

Another highlight was that our portfolio performed well during the quarter, and we did not put any new investments on nonaccrual. As of September 30, we have one nonaccrual, which represents 1% of the portfolio cost and 0% at market value.

Thirdly, during the quarter, we completed the amendment, extension and expansion of the Truist credit facility. The size increased from $465 million to $500 million, and the maturity was extended 3 years until 2027. Thank you to our lending partners for their confidence and support of the company.

And fourth, we continue to grow our PSLF joint venture. The joint venture grew from $608 million to $730 million during the quarter and continues to generate an attractive double-digit ROE for PNNT. We are targeting a $1 billion vehicle over time where we can drive substantial growth in NII at PNNT.

We believe that this late 2022 and 2023 vintage of middle market directly originated loans should be excellent. Leverage is lower, spreads and upfront fees and OID are higher, covenants are tighter and loan-to-value continue to be attractive. Our capital, which we believe is always value added, is adding even more value in this environment. For the quarter ended September 30, we invested $134 million in new and existing portfolio of companies, and had sales and repayments of $176 million.

Now to review the operating results. For the quarter ended September 30, core net investment income was $0.18 per share, including $0.01 per share and other income. This excludes onetime upfront financing costs from the amendment and extension of our credit facility. Our NAV was down due primarily to unrealized mark-to-market adjustments in our portfolio, tied to the overall market and not due to fundamental credit factors. As you might expect, most of the mark-to-market volatility came from our equity portfolio.

Overall, GAAP NAV decreased by 6.9%, comprised of a 3.6% decrease due to the fair value adjustments on our equity holdings and a 2.5% decrease due to the fair value adjustments on our debt holdings. The remaining 1% was attributed to fair value adjustments on our credit facilities.

With regard to increasing net investment income, our strategy remains focused on: number one, optimizing the portfolio and balance sheet of PNNT as we move towards our target leverage ratio of 1.25x debt to equity; number two, growing our PSLF JV with Pantheon to $1 billion of assets from approximately $730 million of assets at quarter end; and number three, rotating out of our equity investments over time and redeploying the capital into cash pay yield instruments.

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. There are business services, consumer, government services and defense, health care and software technology. These sectors have also been resilient and tend to generate strong free cash flow. It's important to note that we do not have any crypto exposure in our software and technology investments.

In many cases, we are typically part of the first institutional capital into a company or a founder, entrepreneur or family selling their company to a middle market private equity firm. In these situations, there's typically a defined game plan in place with substantial equity support from a private equity firm to significantly grow the company through add-on acquisitions or organic growth. The loans that we provide are important strategic capital that fuel the growth and help that $10 million to $20 million EBITDA company grow to $30 million, $40 million, $50 million of 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 platform from inception through September 30. Our $355 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.5x.

With the current volatility in the broadly syndicated market, we have seen more private equity sponsors tap the private credit markets. We are selectively looking at these new opportunities and believe the vintage for these loans will yield compelling returns. Because we're an important strategic lending partner, the process and packaging terms that we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structured transactions with sensible credit statistics, meaningful 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 was so strong and why we believe we're well positioned in this environment.

This sector of the market, companies with $10 million to $50 million of EBITDA, is the core middle market. The core middle market is below the threshold and does not compete with a broadly syndicated loan or high-yield markets. Many of our peers who focused on the upper middle market state that those bigger companies are less risky. That is a perception and may make some intuitive sense, but the reality is different.

According to S&P, loans to companies with less than $50 million of EBITDA have a lower default and higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans more careful diligence and tighter monitoring have been an important part of this differentiated performance. The borrowers in our investment portfolio are performing well, and we believe we're well positioned for future quarters.

As of September 30, the weighted average debt to EBITDA on the portfolio was 4.6x, and the average interest coverage ratio, the amount of which cash interest exceeds cash interest expense, was 3.6x. This provides significant cushion to support stable investment income even when interest rates rise based on this substantial cushion, even with the 200 basis point rise in base rates and flat EBITDA, our portfolio companies will cover their interest 2.3x on average.

Since inception, PNNT has invested $7.3 billion at an average yield of 11%. This compares to a loss ratio of approximately 9 basis points annually. This strong track record includes our energy investments, our primarily subordinated debt investments made prior to the financial crisis and recently the pandemic.

With regard to the outlook, our new loans and our target market are attractive, and this vintage should be particularly attractive. Our experienced and talented team and our wide origination of funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors.

We want to reiterate our mission, our goal to generate attractive risk-adjusted returns through income, coupled with long-term preservation of capital. Everything we do is aligned to that goal. We seek to find investment opportunities in growing middle market companies that have high free cash flow conversion. We capture that free cash flow primarily through debt instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders.

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

Thank you, Art. For the quarter ended September 30, net investment income totaled $0.14 per share, including $0.01 per share of other income. Operating expenses for the quarter were as follows: base management fees was $4.9 million. Interest and credit facility expenses were $13.7 million. General and administrative expenses were $1 million, and provision for taxes was $200,000.

During the quarter, we expensed $5.1 million of credit facility expenses related to the amendment and extension of our revolving credit facility. Excluding the $5.1 million of credit facility expenses, core NII was $0.18 per share.

For the quarter ended September 30, net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $44.1 million or $0.68 per share. The reversal of the provision for taxes of $7.2 million or $0.11 per share was due primarily to the decrease in the value of RAM Energy. Change in the value of our credit facility decreased our NAV by $0.08 per share.

Core net investment income exceeded the dividend by $0.015 per share. As of September 30, our NAV per share was $8.98, which is down 6.9% from $9.65 per share from the prior quarter. Our GAAP debt-to-equity ratio net of cash was 1.2x.

As of September 30, our key portfolio statistics were as follows: our portfolio remains highly diversified with 123 companies across 32 different industries. The portfolio was invested in 51% in first lien secured debt, 11% in second lien secured debt, 12% in subordinated debt, including 7% in PSLF and 26% in preferred and common equity, including 4% in PSLF. The weighted average yield on debt investments was 10.8%.

96% of the debt portfolio is floating rate with an average LIBOR floor of 1%. As base interest rates rise, we are well positioned to participate on the upside. Holding everything else constant in the portfolio, a 1% increase in base rates translates into approximately $0.02 per share of NII upside per quarter. As of September 30, 2022, the company had approximately $0.71 per share of spillover taxable income.

Now let me turn the call back to Art.

Thanks, Rick. In closing, I'd like to thank our dedicated and talented team of professionals for their continued commitment to PNNT and its shareholders. Thank you all for your time today and for your continued investment and confidence in us.

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

(Operator Instructions) We'll take our first question from Casey Alexander with Compass Point.

Yes. Okay. My first question is I'm intrigued by your ability to buy first lien loans in the secondary market. Would these be new relationships or would you be picking up some pieces of loans that you already have? Or what -- is there some sort of breakdown? And what percentage of your new originations in this quarter were as a result of buying first lien loans in the secondary market as opposed to direct origination?

Thanks, Casey. These are typically loans where we feel like we have a differentiated viewpoint where we're not buying the market. It's typically a company we might have financed when it was a little smaller in the core middle market and may be graduated to the broadly syndicated loan market. It's in industries where we think we have domain expertise. We know the management, we know the sponsor, and where we think we're buying $1 for between $0.85 and $0.95.

And we think there'll be a potential pull to par over a 2- or 3-year time period, which gets you kind of the low to mid-teens kind of IRR. So all first lien to secure all credits that we feel are strong credits with good cash flow. It just happened to be a little bit of the baby's gone out with the bathwater in a choppy market environment that we've had.

We -- it's been primarily in this -- in terms of timing, it's been primarily more recently. I mean I think we did a little bit in the quarter ended 9/30. It's certainly a big piece of what we're doing in the quarter that we're in today.

Would you characterize these as broadly syndicated loans or are these private debt loans that are put out by private debt lenders?

No, these are loans where we can access in the broadly syndicated loan market. They trade with the big broker-dealers. And given the market environment, they're at a discount. So in virtually we think we have a different info hedged, but the BSL that, in many cases, graduated from middle market over time.

Right. Okay. Secondly, can you explain why PennantPark takes the $5 million amend and extend fee upfront when most platforms amortize that over the life of the credit facility? And if you'd like to make a case why that's better for investors, I love to hear it.

Yes. So that upfront fee, there's a couple of ways you can do it. Accounting-wise, we are obligated under the way we account for our credit facility to take it upfront as a onetime versus amortizing that over the LIFO loan. So we are taking our pain today. But then we don't have to take the residual expense over the LIFO the loan. Also, from a shareholder standpoint, obviously, this quarter meant that we, as a management company, earn no incentive fee. Again, that's a shareholder-friendly way to do this.

Going back in time and history, back to a global financial crisis, we elected to mark our liabilities to market us. That was a very good matching mechanism for dealing with the SEC asset coverage ratio, and we're still dealing with the residual of that. The SEC would prefer that we don't do that, and we prefer we don't do that. You've seen these credit facilities now are marked closer to par, but we're obligated to do the onetime fee because this credit facility that we keep amending and extending is essentially the same from the accounting standpoint, credit facility that we've had for many years. It's the same lenders. It's the same lead lender. The terms aren't really changing other than the extension. So we're obligated to take -- to see as a onetime hit in this quarter. We do differentiate between core and noncore in our NII disclosure.

And lastly...

Clear...

Probably clear -- more clear to me than most probably. But I actually think it's a very good answer. So that was very helpful. Lastly, on Walker Edison, you marked that similar to where you actually have a partner in that loan that also marked. And Walker Edison has been a company that has given PennantPark substantial benefits in the past.

Do you want to kind of go through the history of that, where you stand with that loan today, what you think is going to happen? And there's also another big private equity shop that is actually behind you on that, that might be helping you drive a positive outcome there? So I would love to hear your thoughts on that one.

Yes. So Walker Edison was a company that we financed, we say, 5, 6 years ago. It's a company that is in the furniture business and their distribution channel is Wayfair, Amazon. It's an e-commerce distribution channel. We get a loan to the company. We took an equity co-invest 5, 6 years ago. It did very, very, very well.

COVID accelerated things. I think our equity co-investment, we had a 4x MOIC in cash. To date, about 1 year, 1.5 years ago, a division of a large private equity sponsor, Blackstone, put $250 million of junior capital into the company. We rolled into a new debt piece with other partners in the direct lending industry. And we felt it was a safe loan, obviously, at that point -- in that point in time. Otherwise, we would have done it, kind of enhanced by the equity cushion by the large private equity sponsor.

Companies massively underperformed since then. The post-COVID world is different, and this company, in and of their own right, did not manage that well. So they did pay us cash interest as of 9/30. So we've leave the 9/30 quarter kept it on hold. Obviously, all bets are off for the 12/31 quarter, and we'll see what happens between now and then. There are restructuring conversations going on as we speak. And I think that's probably all I can report at this point in time.

(Operator Instructions) We'll take our next question from Paul Johnson with KBW.

First one, I just was hoping to understand the mark on RAM Energy a little bit more this quarter, and kind of what drove that markdown? I understand you guys have taken a very patient approach to turnarounds in the past. And there's a lot of moving pieces that potentially go into the valuation here as you guys are evaluating strategic alternatives.

But one of the things I look at -- I mean I'm looking just in the public market comps for E&P companies, the XOP up 6.5% in the quarter. I know oil prices were down in the quarter about 25% or So. RAM Energy, I think this quarter, you guys marked about 32% lower, but a lot of the public comps for energy companies, specifically the E&P sector, is obviously up.

So I'm wondering, is it anything that's going on fundamentally with the operations of the company that would cause you guys to mark the investment down? Or is it related to the strategic alternative exploration process where potentially maybe you've seen lower offers than the valuation in 2Q? But anything that you can say would be helpful.

Thanks, Paul. And we do have to be very careful as the company is exploring strategic options so somewhat limited in really answering the question, Paul, other than to say many factors go into valuation. The price of oil and gas between June 30 and September 30 was down quite substantially, and that was one of the factors that went into the valuation.

Got it. I understand. I understand you can't say a lot. But taking, I guess, a little bit of a step back from the mark on the investment. I'm just wondering -- again, this has been -- I think you guys have had some successful turnarounds in the past, I certainly don't want to take away from that. I think you guys have had the patient approach in the past, that's worked.

But at any point, has this ever become -- does this become essentially like a drain on resources where you have faculty and you have employees and important people, I guess, at the firm that are obviously dedicating time and resources in to turning this around? Does that begin to, I guess, disrupt, I think, the normal course of your just investment process?

Yes. So Paul, just a clarification on your prior question. Just to be clear, RAM is performing well. There's no operational issues. There's nothing new or different on RAM. It's a performing company that's doing well and is healthy.

On the time resource question, look, we may have a different attitude than some of our peers. We get paid to maximize value. And that's what we do. And if it takes time and resources. And we'll do what -- whatever is the best interest of the shareholder. That's what we get paid to do, to try to get the best outcome possible.

Sometimes that means full-blown restructurings, a pivot was a recent example where there was a conversion of debt to equity. We took control. We became a sponsor. We changed management. we dealt with all the various tranches of loans, and we worked with the company to turn around the operations, and we were fortunate enough to exit at a very high price at a really, really good time in hindsight.

And RAM is another one, RAM, we've been longer than pivot, obviously. Our view is this is what we do. And if it takes time and resources, it takes time and resource, that's our job.

I appreciate it. And then just on the secondary purchases you guys made this quarter. Just curious, obviously, you saw good value and you're using your informational and expertise advantage there to potentially make some par trades. But I'm just curious how you evaluate? I guess, those trades. I mean are these secondary purchase just kind of more or less supplementing potentially depressed deal flow or deal volume in the third and fourth quarter of this year? Or are these just very advantageous trades that happen to become available that you felt were good investments for the BDC?

Yes, each investment needs to stand on its own 2 feet. We do, though, compare and contrast and say, "Okay, we can put $1 to work at $0.90 on the dollar or we can do this new loan or we can do both."

How do we look at it? So we're looking at it through the lens of we do not [advance] any capital, we have plenty of capital, but we do not advance any capital. So we do compare and contrast and debate and really try to, through our investment committee, find the best risk-adjusted returns that we can, whether they be in the primary market or the secondary market and do our best to synthesize all that and allocate capital as best we can.

And I mean would you consider those investments to be pulled to maturity type investments that you're planning on holding to maturity? Or are these kind of more held for trading, where if there's any kind of recovery to par you'd be looking to exit?

Sure. So when you're dealing with more liquid investments, like those, if they were to kind of trade from 90 to par, we could say, okay, we could sell this loan at par. We have a new primary middle market loan we can do and question what's the best risk-adjusted return?

In most cases, if these loans get pulled to par, which we hope they do, we would trade out of them and reallocate the money into core middle market originations.

Got it. That makes sense. And then last question, just on your equity co-investment strategy. I'm just curious, I mean that's obviously been a big part of your strategy since you guys have been in business taking equity co-investments. I'm just curious, when you go into a deal, are you essentially given the option of equity co-investment where you can get it and -- versus like fees or OID?

Essentially, do you have the option of one or the other, perhaps exit fees or OID. And if there is an option, I guess, between the 2 when you're evaluating it, you have really a preference for either one. I'm just kind of thinking of a time like now where you're actually actively looking to reduce your equity exposure in the portfolio. I mean is that something you've pulled away from? Or is it still a pretty normal part of the investment process...

Yes, in general, since many of our deals are kind of buy and build, and our debt capital is strategic capital to make that buy and build happen. We feel as though in general, if we believe in the growth of the company, having some form of equity participation makes sense for the debt because after all, we're helping to drive that value. We should or why wouldn't we have some participation in that upside. So by and large, it is something we do and may be a differentiator versus some of our peers.

I think it's particularly important in the buy-and-build growth here types of deals, which is primarily what we're doing these days, right? So it is important. Rarely is it a trade-off, hey, you can get the co-invest, if you take less yield or you take less OID, usually, it's just kind of baked in and part of the understanding that we have with the private equity sponsor that this is how we do business, and it's not a trade-off situation.

In certain cases, they want to limit us or not let us have it, in which case, we sometimes were like, okay, the debt is so good, we don't need the equity. In some cases, we're kind of like, "Okay, the equity is not that attractive. That's fine."

In other cases, it may be a situation where we walk from the deal because we think the equity is a really important part of our package. So we try to look at each deal in each part of the capital structure on their own 2 feet, such that, in some cases, the debt is really good.

We may not be so excited about the equity, and that's fine. In other cases, we may be really excited about the equity and try to get more. So case by case, each piece of the capital structure needs to stand on its own 2 feet, but rarely is it kind of a trade-off scenario.

Ladies and gentlemen, this concludes today's question-and-answer session. At this time, I'd like to turn the conference back to Mr. Art Penn for closing remarks.

Thank you, everybody. Wishing everybody a terrific Thanksgiving full gratitude. Terrific holiday season, and we'll be talking to you next in early February for December 31 earnings. Thank you very much.

Ladies and gentlemen, this concludes today's conference. We appreciate your participation. You may now disconnect.