Pennantpark Investment Corp (PNNT) 2023 Q2 法說會逐字稿

Good afternoon, and welcome to the PennantPark Investment Corporation's Second Fiscal Quarter 2023 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.

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's Second Fiscal Quarter 2023 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 related 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 brief summary of how we fared in the quarter ended March 31, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, then open it up for Q&A.

For the quarter ended March 31, our net investment income was $0.26 per share. Core NII was $0.21 per share and excluded $0.05 of onetime interest and dividend income. GAAP NAV decreased slightly to $7.60 per share from $7.71 per share or 1.4%. This decrease was driven largely by valuation adjustments on our equity co-investments, partially offset by net investment income in excess of the dividend. Our debt portfolio continues to benefit from rising base rates.

As of March 31, our weighted average yield to maturity was 12.1%, which is up from 11.9% last quarter and 8.4% last year. As a result of a stable debt portfolio and growing net investment income, the Board of Directors has approved another increase in the quarterly dividend to $0.20 per share. This is an 8% increase from the prior quarter and a 38% increase from a year ago. The dividend will be paid on July 3 to shareholders of record as of June 15.

We are confident that with the continued strong credit performance, the increased dividend will be more than fully covered by net investment income. For the quarter ended March 31, we invested $58 million in new and existing portfolio companies at a weighted average yield of 11.8% and had sales and repayments of $114 million. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 4.3x.

The weighted average interest coverage was 2x, and the weighted average loan to value was 49%. On March 31, the JV portfolio equaled $748 million. And together with our JV partner, we continue to execute on the plan to grow the JV portfolio to $1 billion of assets. We believe that the increase in scale and the JV's attractive double-digit ROE will also enhance PNNT's earnings momentum. We continue to believe that the current vintage of middle market directly originated loans should be excellent. Leverage is lower, spreads and upfront fees are higher and covenants are tighter. The credit quality of the portfolio continues to perform well.

As of March 31, we had 1 nonaccrual out of 135 different names at PNNT. This represents 1.1% of the portfolio at cost, and 0% at market value. Our investment in Walker Edison has returned to accrual status after completing a balance sheet restructuring. PNNT has an equity ownership in Dominion voting, which subsequent to quarter end settled their lawsuit with Fox News for $787 million. Dominion has communicated their intention to distribute the net settlement proceeds and PNNT share is estimated to be approximately $12 million.

Now let me turn to the current market environment. 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 the company with attractive investment opportunities where we are an important strategic capital to our borrowers. 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, no the right questions to ask and have an excellent track record. They are business services, consumer, government services and defense, healthcare and software technology. These sectors have also been recession resilient and tend to generate strong free cash flow.

In our software vertical, we do not have any exposure to ARR loans. In many cases, we are typically part of the first institutional capital into a company and the loans that we provide on important strategic capital to 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 call investments have been excellent over time. Overall, for the platform from inception through March 31, we've invested over $394 million in equity co-investments have generated an IRR of 26% and a multiple on invested capital of 2.2x. Because we are an important strategic lending partner, the process and package of 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 had 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 are 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 the broadly syndicated loan or high-yield markets. Many of our peers who focus on the upper middle market state that those bigger companies are less risky.

There is a perception that may make some intuitive sense, but the reality is different. According to S&P, loans to the companies with less than $50 million of EBITDA, have a lower default rate and a higher recovery rate than loans to the companies with higher EBITDA.

We believe that the meaningful covenant protections of the core middle market, more careful diligence and tighter monitoring have been an important part of this differentiated performance.

Since inception, PNNT has invested $7.4 billion with an average yield of 12%. This compares to a loss ratio of approximately 22 basis points annually. This strong track record includes our energy investments, primarily subordinated debt investments made prior to the financial crisis, and recently, the pandemic.

With regard to the outlook, new loans in our target market are attractive, and this vintage should be particularly attractive. Our experienced and talented team in our wide origination funnel is producing active deal flow.

Our continued focus remains on capital preservation and being patient investors. We want to reiterate our goal is to generate attractive risk-adjusted returns through income, coupled with long-term preservation of capital. 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 March 31, net investment income was $0.26 per share and core net investment income was $0.21 per share. Core net investment income excludes approximately $0.05 per share of onetime income related primarily to the acceleration of OID amortization in connection with the early repayment of our loan to PRA.

Operating expenses for the quarter were as follows: interest and credit facility expenses were $10.6 million, base management and incentive fees were $7.6 million, general and administrative expenses were $1.1 million, and provision for excise tax was $450,000.

For the quarter ended March 31, net realized and unrealized change on investments and debt, including provision for taxes was the loss of $11.8 million or $0.18 per share. The change in the fair value of our credit facility increased our GAAP NAV by $0.02 per share. As of March 31, our NAV per share was $7.60, which is down 1.4% from $7.71 per share from the prior quarter.

As of March 31, our debt-to-equity ratio was 1.43x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of March 31, our key portfolio statistics were as follows: the portfolio remained highly diversified with 135 companies across 30 different industries, the weighted average yield on debt investments was 12.1%, and the portfolio was invested in 57% first-lien secured debt, 10% in second-lien secured debt, 8% in subordinated notes to PSLF, 5% in other subordinated debt, 5% in PSLF equity and 15% in other preferred and in equity. 96% of the debt portfolio is floating rate with an average LIBOR floor of 1%.

Debt to EBITDA on the portfolio is 4.6x, and LTM interest coverage ratio is 2.8x. The portfolio as a whole has a meaningful cushion with regard to interest coverage. On a sensitivity basis for overall interest coverage to decrease to 1.25x, base rates would need to go up 150 basis points and EBITDA would need to decrease by 35%.

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 would like to open up the call to questions.

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

I just want to make sure I understand this right, but the settlement that you guys announced in the press release last night, the $12 million. So, are we looking at potentially like an $0.18 sort of onetime payment in a future quarter at some point? Is that the correct number? Correct?

Yes. That is correct, Paul. That will come through as a dividend income.

Okay. Is that -- is that reflected in any way in the 3/31 mark? Or is that market pretty much I guess?

No.

Correct. Okay.

No, it is not reflected in the 3/31 mark.

Got it. Okay. I guess just kind of higher-level questions. I guess, in terms of like the opportunity set that you guys see today, in the past, obviously, subordinated second-line type of opportunities, junior capital opportunities have been part of the strategy in PNNT for a long time, the strategy has been moving away from that.

In today's world, I'm just curious, is there -- are you starting to see any sort of attractive opportunities in that part of the market? Or at this point, is there just not enough of a differentiation between the, I guess, maybe the first loan type of opportunities that you're seeing really stretch for junior capital.

Yes, it's a great question. I think we've always even recently been open to second lien mezz. The bar is high. The lesson we've learned is you got to be right and you got to be right quick. because if you're a measure second-lien 4 years down the road, something didn't go right. So we're still open to mezz and second-lien.

Some of the mezz today has a big PIK portion because so much cash pay EBITDA is going towards paying the first-lien. We're not a lover of PIK. So our funnel for mezz in second is going to be a little bit more selective.

That said, the subordinated debt and equity that we buy in our joint venture, this PSLF joint venture, where it's mostly first-lien collateral underlying the portfolio, and we leverage it up a little bit more than what's in the BDC. It's a very attractive return on invested capital backed by cash pay, conservatively structured senior debt. So that's kind of been where we're getting the incremental juice in this portfolio is kind of building that JV.

I think as of quarter end, it was about $750 million of assets. For us, it was about $150 million investment and continuing to grow that is a very -- we think a very nice way to get some incremental yield on the portfolio in a safe way.

That makes sense. And that's helpful color there. On the opportunity set. Last question, just on -- kind of broadly on your equity co-investments. I guess are those investments, over time, are they pretty much entirely dependent on some sort of M&A event from the sponsor, basically a sale of the business and exit that business for realization of that equity co-investment? Or are there other ways that can be constructed over time, I guess, for you guys to potentially cash out on some of those investments?

Yes. So good question. We're going in kind of heads up with the sponsor. We've had a very good long-term 2.2x MOIC over 17 years on that capital, so it's been very accretive. And just like the sponsor, there's an M&A exit, there's a potential IPO exit. And then there's certainly dividends that can come out of that. The Dominion Voting situation, that will be a dividend coming at us out of the company because we're an equity shareholder. So really aligning ourselves.

I guess we could sell our equity to the sponsor if we need or want liquidity. We haven't needed it, and you generally don't like being on the opposite side of someone who may have slightly more information than you have. So we haven't elected that route, but we could if we need or want liquidity, sell these stakes back to the sponsor.

That makes sense. And one last question, if I may. Just going back real quick to the settlement payment in future quarter. Do you guys have any thoughts on in terms of how you guys are going to treat that income special, maybe like a special onetime dividend retained part of any sort of thoughts there on how you're going to treat it?

Yes. So look, we always evaluate. I don't think we have any predisposition. We're building some nice spillover, and that will go into kind of our dividend policy over the next year, 1.5 years. You saw a very nice bump in the dividend this quarter. We think it's sustainable based on ongoing NII, and we have this nice kind of spillover that can potentially go into protecting that dividend over time.

We'll take our next question from Robert Dodd with Raymond James.

Congrats on the quarter. Quick question on (inaudible) Any visibility to the timing? I mean, obviously, it will be a fairly significant benefit when it does occur to shareholders. So is it likely to occur in the June quarter or later just from [model terms]?

Yes. We've been led to believe that will happen in this quarter that we're in right now, the quarter ended June 30.

Got it. Then also the equity. Obviously, it has been declining as the portion of the portfolio. If we take out the JV, still coming in mid-teens. The target is lower than that. I mean, obviously, to your point, that you answer your scope potentially liquidate it but not necessarily how to do so. But how fast do you think -- how would you expect that to come down towards your target of 10-ish excluding the JV?

It's a great question. And yes, look, it's tied to M&A deal flow. M&A deal flow, as we all know, has been slow year-to-date. So what normally -- when you make a private equity investment, people normally say it's a 3- to 5-year life, and maybe things have been extended a year due to the market environment. So look, I think we hope that over the next year or 2, we're going to be able to get some reasonable exits and bring it down. I mean back to the last question about Dominion, it wasn't even included in the NAV for the March quarter because we did not know it was an event as of March 31.

You could have put that $12 million into the mix and said, gee, your equity percentage is higher than 15%. And that would have been right, although this was kind of a positive surprise out of the blue. So I don't know. Again, I can't really give you an answer. We're doing our best. We're not in control of much of this. But kind of knowing that over time, we've had well in excess of a 2x MOIC on this capital. You just got to kind of wait until it happens.

We'll take our next question from Kyle Joseph with Jefferies.

Just wanted to talk about the originations environment and kind of walk us through the cadence in the quarter. Obviously, deal closed, light again, M&A light out there. But in terms of timing or January and February, fairly kind of consistent. And did you see a big fall off kind of in March post all the regional bank volatility? And how has deal flow been kind of quarter-to-date?

Yes. So Q1 -- calendar Q1 was slow as it normally is slow. It seasonally is normally a slow quarter. Made slower this year by the turmoil and the capital markets and the rising interest rates, made even slower since the banking situation, the banking kind of issues that we've had. So what's going on is buyers and sellers, to a large extent, are still trying to figure out where they meet. Sellers still are hoping for a value like it was a year or 2 ago, and buyers are baking in higher interest rates and a potentially softening economy. So until there's equilibrium between buyers and sellers, there's not going to be a lot of deal flow. That's statement 1.

Statement 2 is we are starting to see more deal flow. So we are starting to see buyers and sellers get together, and our deal flow is picking up. No guarantees as to what's going to close between now and June 30, and what's going to close after June 30, but it does feel like the second half of 2023 will certainly be busier than the first half.

All right. Got it. And then on the repayments, were a little bit elevated in the quarter. Just wondering, is that RAM, some other onetime things in there? Obviously, it's never bad to get paid back, and never bad to get paid back when it really boost your other income, but just kind of I'm wondering if that's a one-off or a trend.

Look, RAM by definition, is one-off, and that happened in the past quarter. And PRA which is this corporate events company that we invested in, that was exited and that's where that onetime noncore positive fee came in, from that exit. It was a company that -- it's a corporate events company. So by definition, in the middle of COVID, it was struggling. And as you can probably sense, people are getting out in the mountain, traveling, and corporate events have blossomed post-COVID. So that company really paid us back well and early. And we had a very nice exit fee as part of the redo of the capital structure in the middle of COVID, which generated the onetime fee income.

So really, those are the 2 primary drivers. I mean are they onetime or ongoing? We'll see. We certainly -- you're going to have certainly the companies that are tied to events and tied to travel. We have some trade show businesses, for instance, that were getting hurt in COVID. Those companies are now obviously doing very well. So there might be more of that, and that is a piece of the portfolio. It's not an oversized piece, but it's a piece of the portfolio, and those companies are doing well.

We'll take our next question from Mickey Schleien with Ladenburg.

Art, a lot of discussion about how folks are so excited about the current vintage of deals, and I would definitely agree. I'm curious whether you're being able to structure terms in these deals that will allow them to stay on the books as long as you would like, given how attractive they are, whether it's the tenor or the prepayment penalties that you're building in or anything else that you're able to do to try to ensure that this will show up in the income statement a couple of years from now.

Yes. It's a good question, and kind of the average investment in this last quarter. Debt-to-EBITDA 4.3x, very attractive. Interest coverage, 2x. And LTV, about 50%. So this is an attractive vintage, and I guess that's the blessing of the equity co-invest. That's our tail. When companies do well, we have that tail. And we participate, and the company is doing well.

We've had deals in the last 6 months where even post-banking situation, the company deleveraged to 2x or 3x debt to EBITDA, and the commercial bank took us out. That's great. If we're in the equity, we are participating in a lower cost of capital. By definition, it means the company is a good free cash flow generator. And at some point, that equity value will be ascertained in some way, shape or form. Dominion Voting paid off the debt, I don't know, 2 years ago. So we still have this residual equity co-investment, which is paying off.

We'll take our next question from Mark Hughes with Truist.

Yes. Is there any potential variability in that Dominion payout? Or is that pretty well set? Or there any final wrangling on the numbers?

No, we were -- that's why I say approximately $12 million. It's -- there's still -- there's legal fees and taxes that kind of come off the top, but it's kind of pretty in that zone -- pretty much in that zone.

Yes. Art, what is your opinion on the credit environment here? We've been kind of tipping into a recession for 2 years now. I'm just sort of curious how you think the economy is shaping up. You've got a unique view from where you sit. What's your stand?

It's a mixed economy, certainly not what it was coming out of COVID, which everything was going gangbusters. The consumer is particularly mixed fees. The consumer on one hand is happy to go take trips and go take cruises and hop on planes and stay in hotels. On the other hand, when it comes to goods, has been more cautious buying furniture.

Walker Edison, a prior non-accruals furniture company. So Walker Edison did great during COVID and is doing much softer now. So to bifurcate consumer, you got to be careful in the consumer space. So it's much more kind of mixed. I think obviously, when we underwrite credit here, we assume there's a recession. There may not be one. We may be able to skate by, which would be nice.

But we assume there's a recession. And when we do our credit underwriting, we're putting that in the model to see how these companies would perform in a recessionary case. That's our assumption as prudent credit underwriters. Our house view is probably there might be a light recession, but that doesn't impact our -- how we underwrite. We underwrite for a recession.

Yes. How bad would the recession have to be for it to be material for the portfolio?

Hard to say. I mean, I think Rick in his numbers gave the sensitivity around EBITDA, would have to go down something like 35%. And at the same time, which is contradictory, base rates would have to go up 150 basis points, and you're down to 1.25x EBITDA to interest coverage. Obviously, if the economy is soft, the Fed is probably not raising rates, right? So that's kind of an interesting thing to think about, which is if the economy is soft, the Fed is probably reducing the rates, which will increase interest coverage. The yields will go down. We, of course, have floors, but the yields would go down. But I think you can do the work as much as I can. I think in an environment where yields are going down, investors may flock to yield vehicles like BDCs to take advantage of high yields. So we don't know the scenarios.

We'll take our next question from Melissa Wedel with JPMorgan.

Wanted to touch on the dividend increase in the June quarter. It's -- I think it's like the sixth quarter that you've done an increase to the dividend. Just thinking ahead, do you -- are you thinking about this dividend increase a little bit differently than the rest? Does this feel like maybe with where the forward curve is projecting right to go that this might be a good place to pause? Or will you keep evaluating? Or...

Yes. I'm going to sound a lot like the Fed with my answer, Melissa, which is we're going to let the facts and circumstances dictate how we go. I mean the various facts and circumstances would be kind of how is our JV expansion going. And is that going to continue to be able to generate more ROE? How is our rotation of equity going? Obviously, equity rotation, and even things like Dominion, where we have fresh equity powder, how is that looking to be able to rotate that into yield?

How's our spillover looking? We have substantial spillover. That's on the positive side. And then on the potential issue side is where our defaults and non-accruals, where our long-term rates and our cost of financing. So I think every quarter, we do our best. We look at the facts and circumstances and do our best. We're very pleased that we've taken the dividend up from $0.12 to $0.20 in a relatively short period of time, which does, in fact, mimic the NII and earnings of the company, and we'll see where we go from here.

All right. Fair enough. Thinking about portfolio leverage and where you guys are at now, certainly, there's been rotation in the portfolios. But leverage is still fairly high. It doesn't sound like you're particularly pessimistic from a macro perspective. But how are you thinking about portfolio leverage? And where would you like to run that in an environment with the opportunity set that you're seeing today?

Yes. And we did -- I think we mentioned in our remarks, we're targeting -- we target at 1.25x. So we're a little overlevered at this point. We're confident that with some repayments and some equity rotations, we can easily glide down to that. We are conscious of our credit rating. It's important for us to -- for attractive debt capital to keep a strong credit rating. So we'll gradually let it grind down to 1.25-ish, 1.25 area over the coming time period at the same time as we try to optimize the joint venture and the financing and the JV and the ROE from the joint venture at the same time as we try to rotate equity.

We'll take our next question from Casey Alexander with Compass Point.

I have 2 questions. First of all, in relation to Dominion, I'm going to ask you to put my hat on for a second and ask, would you model it in? And if you modeled it in, what quarter would you model it into?

Again, we've been told that it's this quarter ended June. Never any guarantees, but that's what we've been told. I'm just giving it to you straight. And to us, it's just -- it's a -- you can't say it's recurring. I mean this is -- it's kind of like sometimes when you get your equity co-invest really blossoms into something great, you can't really model it. It's just like nice upside to offset the inevitable downside you have as a lender from time to time.

So when we think about kind of what it means to NII in dividend, it's obviously not recurring. Next quarter, hopefully, it will be in there, and we'll say it's nonrecurring. It does build spillover, though, right? So as we think about long-term dividend policy, it does impact that.

Yes. And that's a good view. And I believe a previous question said $0.18 a share. I think when you net it out versus incentive fees, it's more like $0.14 or $0.15 a share, I think, is the real impact.

My second question is the -- I realize it's a small position, but the restructured loan of Walker Edison, my understanding is that it's a 100% PIK. Did you consider leaving it on nonaccrual for the time being until such point in time as the company is able to turn that into more of a cash pay instrument?

Yes, it's a good question. I think the independent valuation firms are marking that instrument at par. It's a good question. By the way, it's not really material in PNNT at this point anyway. But it's a good question. I think our valuation firm said, hey, it's a par instrument. Granted if in a couple of quarters, the company doesn't perform well and it starts to get marked down, I think we'll take another look at that.

Again, thankfully, it's not that big of an investment for us at this point. It's underperformed. We're certainly hopeful that the company will find its footing and people will buy furniture from this company, and it will have a steady EBITDA. And at some point, we certainly hope our debt is paid off and our equity has value, but it's early days.

All right. Well, and I'm fully cognizant that in your -- actually, your original investment in Walker Edison, you guys took a very attractive game. So there is 2 sides to this story.

That will conclude our question-and-answer session. At this time, I'd like to turn the call back over to Mr. Penn for any additional or closing remarks.

Well, thank you everybody for being on the call today. We'll talk to you next time in early August for our June 30 numbers. Thank you very much.

Thank you. That will conclude today's call. We appreciate your participation.