Pennantpark Investment Corp (PNNT) 2024 Q4 法說會逐字稿

Good afternoon and welcome to the Pennantpark Investment Corporation's fourth fiscal quarter 2024 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 fourth fiscal quarter 2024 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 call -- 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 the current market environment for private middle market credit, how we fared in the quarter ended September 30, 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 September 30, our GAAP and core net investment income was $0.22 per share. GAAP and adjusted NAV increased to 0.5% to $7.56 per share from $7.52. The increase in NAV for the quarter was due primarily to net positive valuation adjustments in the investment portfolio. As of September 30, our portfolio totaled $1.3 billion. And during the quarter, we continued to originate attractive investment opportunities and invested $192 million in 12 new and 44 existing portfolio companies at a weighted average yield of 11.4%.

We continue to see an attractive vintage in the core middle market. For investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.6 times. The weighted average interest coverage was 2.4 times, and the weighted average loan-to-value was 36%. As of September 30, the portfolio's weighted average leverage ratio through our debt security was 4.5 times and the portfolio's weighted average interest coverage ratio was 2.0 times. These attractive credit statistics are a testament to our selectivity, conservative orientation, and our focus on the core middle market.

During 2024, the market yield on first lien term loans has tightened 50 to 75 basis points. As the credit statistics just highlighted indicate, we continue to believe that the current vintage of core middle market directly originated loans is excellent. In the core middle market, leverage is lower, spreads are higher, and covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market, in the core middle market, we are still getting meaningful covenant protections.

During the quarter, PNNT's joint venture, PSLF, accepted $127 million of additional capital commitments from PNNT and its JV partner. PNNT committed $52.5 million and the JV partner committed $75 million. In addition, the JV increased its senior secured credit facility from $325 million to $400 million. This additional capital will allow the JV to scale its investment portfolio to over $1.5 billion, representing a nearly $500 million increase in the JV's investment capacity. At September 30, the JV portfolio equaled $1 billion. And during the quarter, the JV invested $146 million, including $105 million of purchases from PNNT.

Over the last 12 months, PNNT earned a 19.2% return on invested capital in the JV. We expect that with continued growth in the JV portfolio, the JV investment will enhance PNNT's earnings momentum in future quarters. The credit quality of PNNT's investment portfolio remains strong. We had only two nonaccruals as of September 30. Nonaccruals represented 4.1% of the portfolio at cost and 2.3% at market value.

Now let me turn to the current market environment. We are well positioned as a lender focused on capital preservation in the United States. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities where we provide important strategic capital to our borrowers. We have a long-term track record of generating value by successfully financing growing middle market companies in five key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask, and have an excellent track record. They are business services, consumer, government services and defense, healthcare, and software and technology.

These sectors have also been recession resilient and tend to generate strong free cash flow. The core middle market, companies with $10 million to $50 million of EBITDA, is below the threshold and does not compete with the broadly syndicated loan market or the high-yield markets, unlike our peers in the upper middle market. In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive is attractive.

We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads and equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies.

With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated first lien loans have meaningful covenants, which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. Many of our peers who focus 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 rate and higher recovery rate than loans to 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.

As a provider of strategic capital who fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company 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, we invested over $540 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2 times.

Since inception nearly 17 years ago, PNNT has invested $8.3 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of approximately 20 basis points annually. This strong track record includes investments of primarily subordinated and debt investments made prior to the global financial crisis, the legacy energy investments, and more recently, the pandemic.

With regard to the outlook, new loans in our target market are attractive. Our experienced and talented team and our wide origination funnel are producing attractive deal flow. Our continued focus remains on capital preservation and being patient investors. We want to reiterate our goal 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 September 30, GAAP and core net investment income was $0.22 per share. Operating expenses for the quarter were as follows: interest and credit facility expenses were $12.3 million. Base management and incentive fees were $7.4 million. General and administrative expenses were $1.75 million, and provision for excise taxes were $0.7 million.

For the quarter ended September 30, net realized and unrealized change on investments and debt, including provision for taxes, was a gain of $4 million. As of September 30, our GAAP and adjusted NAV was $7.56 per share, which is up 0.5% from $7.52 per share in the prior quarter. As of September 30, our debt-to-equity ratio was 1.57 times, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt.

As of September 30, our key portfolio statistics were as follows. The portfolio remains highly diversified with 152 companies across 33 different industries. The weighted average yield on our debt investments was 12.3%.

We had two nonaccruals, which represent 4.1% of the portfolio at cost and 2.3% at market value. The portfolio is comprised of 55% first lien secured debt, 5% second lien secured debt, 9% subordinated notes to PSLF, 5% other subordinated debt, 6% equity in PSLF and 20% in other preferred and common equity. 94% of the debt portfolio is floating rate. and the debt-to-EBITDA on the portfolio is 4.5 times and interest coverage is 2 times.

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) Mark Hughes, Truist.

Yeah, thank you. Good afternoon. The investment activity so far in the fourth quarter, I'm not sure if you gave any specifics on that, but what have you seen so far?

Yeah. Thanks, Mark. We've been active kind of with PNNT's current situation. PNNT is kind of pretty fully levered at about 1.5 times. Our long-term target leverage is targeting about 1.25 to 1.3 times. So what PNNT does is it basically buys deals and seasons them. And then at some point, the JV will then purchase those deals.

So the growth of the portfolio in PNNT is really going to come through the JV at this point. So it's kind of been more of a steady state at PNNT and the new deals and new opportunities given the leverage are going to be shifted over to the JV when appropriate. So kind of ins and outs are monitored very closely, and we've been active, but we're also getting repayments.

Yeah, okay. And then you described kind of high teens returns on the JV. Anything structurally that should influence that? Is that kind of sustainable? Is there decent visibility for those sort of returns? Are there any market factors that maybe influence that?

Sure. It's a lot of the first lien deals that we originate across our platform, lower leverage, lower risk-type deals. And then as they go into the JV, they get levered up a little bit more than they were on the BDC balance sheet, kind of 2:1 kind of debt-to-equity ratio range. And we use credit facilities and we use CLO technology to finance those loans.

So certainly, same thing as a BDC balance sheet. If interest rates come down, the returns on that JV will come down. These are mostly or virtually all floating rate loans, granted the cost of liabilities will come down as well.

And then credit performance. We've had excellent credit performance in the JV. Hopefully, we continue to have excellent credit performance, but a combination of interest rates and credit performance would be the key areas that you'd watch for that 19% return coming down.

Very good. And then thinking about the credit stats this quarter, the -- I think 3.6% or 3.6 times debt to EBITDA and then it seems like a loan-to-value also pretty attractive. At the same time, you're getting a little bit of spread compression. What are you seeing just in terms of those leverage numbers? They seem pretty good. Is that sustainable or you might see those move up a bit?

Yeah. Look, they're really good. From an overall standpoint, we end up being in the mid-4s over a long-run basis. And as we say, typically, we'll start out with a company that's a platform for growth or acquisition. So we'll finance a $10 million or $15 million or $20 million EBITDA company. Once a little smaller, we might keep leverage a little tighter. As the company grows to $20 million, $30 million, $40 million of EBITDA, it gets a little bit bigger. Maybe the leverage will go up a little bit as it does add-on acquisitions and draws down the delayed draw facilities.

So that's the typical life cycle of one of our deals. We'll start out smaller EBITDA, keep leverage tight, give them a DDTL to grow, co-invest in the equity to participate in that growth. The company gets bigger, ends up at 4, 4.5 times leverage. And then as it gets to 40 or 50 of EBITDA or greater, it moves off to the upper middle market.

Appreciate that. Thank you.

Robert Dodd, Raymond James.

Morning. Hi guys. On the outlook in terms of sectors, I mean, you mentioned obviously five key sectors. I mean, when I look at the adds this quarter, I think three or four of them were healthcare mostly and then business services, only one government/defense. What are the ones that look appealing to you going forward into 2025, maybe with taking into account, obviously, change in administration coming, et cetera? I mean, which areas do you expect to remain attractive?

Yeah. Look, I think our two biggest sectors and some of those business services might, as you look under the cover, be a little bit more government services or defense. Look, healthcare has been a good sector for us. Some of our peers have stumbled a little bit in that space. I think we generally tend to keep leverage lower than some of our peers. Maybe we're financing smaller companies at lower leverage with tighter covenants, I don't know. But we've selected areas in healthcare where the tailwinds are behind us, the reimbursement risk may be a little lower. And importantly, we keep leverage lower.

And demographically, healthcare is just going to continue to be a big portion of our economy. You almost can't avoid it, the aging of our population. So we're going to continue to do a bunch in healthcare. We're going to be very selective about which pieces of the industry and then keep leverage low.

Government services and defense continue to be an important part of the economy. The geopolitical outlook remains uncertain. Certainly, with DOGE coming in and taking a look at all government expenses, that's -- we'll see how that plays out. As taxpayers, we, of course, want our tax dollars to be spent efficiently.

But typically, in defense and government services, we're financing service businesses where human beings walk into an office building and sit behind computers, whether that be cybersecurity, intelligence, other kind of non-heavy asset areas that we think will continue to be really important given the geopolitical risk that's in the market. But it's really hard to handicap what the DOGE effort is going to mean.

And kind of -- again, we just try to keep leverage low. I don't know how many of our peers have a portfolio that has a debt-to-EBITDA kind of in the mid-4s and has new loans in the mid-3s debt to EBITDA. I don't think there's very many. So for us, that's been our tactic or strategy.

And we're okay keeping lower leverage and accepting a lower yield. And with the advent of being able to efficiently finance those loans either on the balance sheet of the BDC or in a JV where leverage can be optimized a little bit more, and we can manage more assets on behalf of the shareholder and not charge a management fee for managing those assets and be able to punch out a mid- to upper teens return. We think that's a very good model for PNNT.

Got it. Thank you. On that -- the spread question, I mean, they have come down. You mentioned in your prepared remarks. I mean, where do you -- do you think it's at a bottom that spread compression has kind of leveled out given -- or do you think there's -- the returns on first lien is still really, really attractive. I mean, double-digit yields on first lien even with spreads where they are right now. So I mean, do you think there's room for them to come down further? Or is this the bottom or thoughts there?

Yeah, a great question. We think they've plateaued here. Our deals are typically right now on the senior side, 5 to 5.50 spread over the risk-free rate. It seems to have plateaued. If deal supply gets even heavier, perhaps we have a chance as an industry or in the core middle market to be able to increase spread a little bit. If there's heavy supply, that won't be so bad.

Again, credit, credit, credit, that's got to be most important. If we can reduce mistakes, the rest of it will take care of itself. So we're not modeling an increase in spread. And right now, we don't think there will be any tightening. And on a relative value, if you look at the BSL market, BSL market is kind of 3.50 spread. So if we're 5.50, BSL 3.50, from a relative value standpoint, we still think it's attractive.

Got it. Thank you.

Thank you.

Paul Johnson, KBW.

Good morning. Good afternoon. Thanks for taking my question. So on the JV, very strong returns in the quarter. It's been a great asset for the BDC, a 19% annualized distribution rate from the JV this quarter. Portfolio yield close to 11% inside of the JV. Can you kind of give your thoughts around just sustainability of that current distribution rate? I mean, even some sort of -- any sort of sensitivity around interest rates and what would happen with net interest income in the JV?

Yeah. It's a great question. And certainly, our track record in the JV to date is really good. We've had very minimal nonaccruals. Look, you have to kind of say, let's build in some cushion in that. If you were to kind of say, okay, long run, can -- we're four or maybe five years into that JV, can we sustain it? I certainly hope so. But certainly, over time, we have nonaccruals, and we should model those in.

For PNNT over many years, it's been a 20-basis-point annualized diminution of returns due to nonaccruals. The PFLT and the JV portfolio is a little bit closer to the PFLT. First lien portfolio has been 10 basis points annualized. Certainly, as interest rates come down, it's going to be sensitive to that. So those are the two things you'd model in.

Is 19% going to come to 17% or 15% at some point? It's quite possible. It's hard to guarantee 19% forever. I mean, I certainly hope we can achieve that, but it's really hard to say it's absolutely sustainable and pound the table on that. But certainly, the way we've been investing in senior debt and then how we've been using leverage at the JV level, including securitization, CLO leverage, we should still be able to get an upper teens return on that capital.

And what is the idea around leverage? I think last quarter, it was around 2.1 times or so in the JV. Is the idea to continue to increase that as rates decline? Is that kind of near its sort of max target leverage? What's the idea?

Yeah. I think 2:1, 2.25:1 is probably the relevant zone at this point. Again, these are the same exact assets that we use across our platform, PFLT and its JV gets these first lien assets. It's important to note that we have a CLO business, a third-party CLO business, and these same assets are in middle market CLOs, where the equity gets levered 3 or 4:1. And those are very strong good structures.

We are going to price our CLO 10 shortly in the coming days. And if you look at third-party research on middle-market CLOs, thankfully, PennantPark is one of the top three quarter after quarter in terms of performance in middle market CLOs. It's because the performance of the underlying assets so far has been very good, and the same assets that are in our JVs, so -- and in PFLT. So these assets could be safely levered 3 or 4:1. In the JV right now, we're focused on 2 to 2.25:1.

Thanks for that. And then can I just ask about the amendment this quarter in the JV? It looks like you made an amendment that allows parties to potentially redeem their interest. What's the idea with that? Is that to potentially create some sort of opportunity to maybe bring new partners in, in the future somehow or to sell stakes? Or what was the purpose of that amendment?

Yeah. That was just kind of in line with the updated agreement we have with our JV partner. They were bringing more capital in. As part of that, they just wanted to clarify entry and exit mechanics. So there's a potential that this really could just be an evergreen vehicle and their limited partners can come in and exit on an orderly basis if they want to continue to be in this vehicle.

Thanks for that. And then on the nonaccruals, in the filing, it says there's two companies on nonaccrual. However, if I pull up the number of companies on partial nonaccruals, there's a few more. Can I just ask why would a company be placed on partial nonaccrual versus just full nonaccrual? Was there any specific situations this quarter or reason for that?

Rick, do you want to handle that one?

Sure. Thanks, Paul. There's one company -- it's called Pragmatic that's on partial nonaccrual. Based upon the valuation, which is in the low 60s, it is currently paying PIK interest. So we're accruing to that mark of 60 because the enterprise value of the company is not -- it's basically at 100% loan to value. So we're reserving for that portion that exceeds the enterprise value and then therefore collectibility.

Appreciate that. And then just a few more, if you may. Within the portfolio, what would you say, I guess, is the refinancing opportunity that's still left in the portfolio at this point? I mean, how -- what would you see as kind of like the balance between activity that can be derived from the existing book versus new activity kind of given that leverage is obviously kind of getting close to being maxed out within the BDC?

Yeah. We're getting repayments. Middle market M&A is getting active again. I think we were on the PFLT call earlier. It's an active environment for middle market M&A. We hope to be getting some realizations on our equity co-invest portfolio as part of that. Certainly, we're going to get repayments on loans as part of that.

And the idea is to optimize that portfolio, optimize the JV portfolio and manage it sensibly and tightly. But the wheels of commerce and the wheels of M&A are picking up again. And hopefully, that will provide us an ability to get some equity realizations and make the equity piece of the book a smaller piece of the book.

Thanks for that. I mean, would you say that any of your larger equity co-investments are getting any closer to that point of exit if we do see a material pickup in M&A activity next year?

Sure. I mean, you can -- it's a simple review of the equity co-investment and look at fair market value relative to cost. And if there's -- the fair market value is a lot higher than cost -- and typically, we're a co-investor with a private equity sponsor, typically, it's just a matter of time, right? So we're hoping to get some nice realizations in the not-too-distant future.

Appreciate it. Thank you very much, Art. That's all for me. Thank you.

Melissa Wedel, JPMorgan.

Good afternoon. Thanks for taking my questions. Most of mine have already been asked, but I thought I'd follow up on the JV, in particular. As you talk -- you mentioned that the growth in the portfolio is likely to come through that JV. It certainly makes sense with the recent upsize. When you think about the investment in the JV, both in the sub debt, but also the equity investment, how do you think about position sizing of that JV investment within the total portfolio context? Do you think of -- is there some constraint in terms of position size that you would be targeting or not be comfortable exceeding in the portfolio? Thank you.

Yeah, that's a great question. So the JV itself with about $1.5 billion of availability for that particular bucket, let's just say, average position should be 2%. So that's up to $30 million. And I think in reality, the average position there will be about $25 million. If we were to do a new loan, that JV would take $20 million to $25 million in and of itself. So very diversified portfolio in the JV. And then the question is what's too big for PNNT in terms of its position in that JV?

Look, we're getting pretty full. Just to be quite honest, we're getting pretty full. It is part of our 30% bucket, which is getting pretty full. So we're getting there, not to say we're there, but it's going to be a pretty full position. And you saw that we -- prior to this investment, we -- PNNT owned 60% of the JV, our partner on 40%. We did not take 60% of this upside. We took less. They took more. So I think we're probably about 55%, 45% now. So something we evaluate. That said, when you look at the underlying portfolio, the underlying portfolio, obviously, is very, very diversified.

Understood. Thanks, Art.

Casey Alexander, Compass Point.

Yeah, I've got a few. One in particular, J&F equity position that was marked up $9 million this quarter. That was a pretty extreme mark-to-market quarter-over-quarter on an equity position, one of the few equity positions that really is large enough that if it got monetized, it could really help your income producing, your income generating in terms of switching it to stuff that does generate income. Does that one, in particular, appear to have some sort of a path towards monetization because all of a sudden -- because usually, when we see a large quarter-over-quarter markup like that, it may mean that something is more current.

Yeah, that's -- we just said that, hey, when there's a big markup of the equity, it's just -- hopefully, it's just a matter of time, although we never want to overpromise and underdeliver. And occasionally, we've underdelivered on that score, Casey. So do not want to overpromise and underdeliver, but that deal has been marked up and the company is performing well.

All right. But secondly, and as you say, you are -- you're the 45% in the JV, right?

In this last iteration, but overall -- no, overall, today, we're about 55%.

PNNT is 55%. Okay, yeah. Because it could be the first JV I've ever seen where the balance sheet is going to be larger than the -- on company balance sheet. But let me ask the balance sheet -- on Pennant's balance sheet as well as the debt that it has also has $100 million payable for investment purchase. And so that would make the effective leverage around 1.7 times.

So obviously, you're warehousing a little bit for the JV. And when you bring that down, when you move those over to the JV, the appropriate investments to get it to where you want to be and bring your leverage ratio back down to your target leverage ratio, I'm struggling a little to figure out how that is going to be accretive to earnings if 100% of the income is on balance sheet shifting to 50% of the income going off balance sheet. Is it just because you have so much additional leverage in the JV that you're able to squeeze out some accretion to earnings from that?

Yeah. So it's a great question. Every dollar we invest in the JV, whether it's earning at 19%, which is terrific or something a little bit less, is obviously accretive to NII. So that's very helpful. And we're earning some income along the way.

But the question is like, hey, when the dust settles, once the JV is fully optimized to $1.5 billion and this incremental capital that we're putting in, what do those economics look like, and we can work through that model with you, Casey, on the incremental capital we're putting in the JV and how that works its way back to PNNT.

And then yes, we are looking forward to some equity rotation in this M&A world that seems to finally have revived after a couple of years of being sleepy. And I think those are the two drivers for optimizing NII is the JV and the equity rotation.

Okay. My next question is you have 152 companies in the portfolio, 12 of which were new this quarter, which means that 140 are legacy companies. And you did add-on investments to 44 companies, which is over 30% of the portfolio.

It's hard to imagine that over 30% of your portfolio was getting bolt-on growth capital. It feels like there may be some maintenance capital that's helping these companies pay the coupon on their debt. And PIK income is already 13% of the total portfolio. Can you talk to those 44 and how many of them are kind of maintenance capital versus ones that are really requiring additional bolt-on growth capital?

I'll kick it over to Rick in a minute because some of this might just be revolver draws. So I don't know, Rick, how much of that's revolver. We do have a very active portfolio. Again, most of the deals we're doing, you're taking a $10 million or $15 million or $20 million EBITDA company and you're -- there's a real game plan to grow it to $40 million, $50 million and greater. So the DDTLs are an important piece of the add-on loans we're making. Rick, the revolver -- are revolvers included in some of those numbers Casey was referring to?

Yes, Art. The $44 million add-on does include revolver draws. And I would guesstimate that that's probably about 85% is related to revolver draws as opposed to add-on acquisitions and DDTL.

Okay, great. Thank you for taking my questions.

Thanks Casey.

And that does conclude the question-and-answer session. I'll now turn the conference back over to Mr. Art Penn.

Just want to thank everybody for being on the call today in the season of Thanksgiving. I want to express gratefulness and thankfulness to everybody who's on the call and your interest in PNNT. Wishing everybody a terrific holiday season, and we'll talk to you in February.

Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day.