Pennantpark Investment Corp (PNNT) 2022 Q2 法說會逐字稿

Good afternoon, and welcome to the PennantPark Investment Corporation's Second Fiscal Quarter 2022 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 2022 earnings conference call. I'm pleased and I am joined today by Richard Cheung, our Chief Financial Officer. Richard, please start off by disclosing some general conference call information and include a discussion of our 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. 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'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, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ending March 31st, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, then open it up for Q&A. From an overall perspective in this era of inflation, rising interest rates and geopolitical risk; we believe that we are well positioned as a lender focused on the United States where the floating rates on our loans can protect against rising rates and inflation. We are pleased to be lending into the core middle market where we loan important strategic capital to our borrowers and our non-commodifiers. We believe we are additionally well positioned as a company that has a clear game plan for growth in net investment income and dividend.

The highlight of the quarter ended March 31st was the sale of Pivot Physical Therapy, which generated cash proceeds of $232 million; our second lien position, which had a cost of $49 million; and cash proceeds of $78 million resulting in an ROI of 14.3% and a multiple on invested capital of 1.6x. Our common and preferred stock investments, which had a cost of $35 million, was exited for $164 million resulting in a 40% IRR and a multiple on invested capital of 3.3x. Due primarily to this successful exit of Pivot, we have made progress on our 3-part plan to increase long-term shareholder value. Number one, last quarter we increased our quarterly dividend to $0.14 per share, up from $0.12. We're announcing another increase this quarter to $0.145 per share. Number two, we made progress on our $25 million stock buyback program by purchasing 913,000 shares for $7 million.

Number three, we completed a CLO securitization financing in our PSLF JV with Pantheon, which gives the JV ammunition to grow to about $750 million and enhance PNNT's NII over time. Now to review the operating results. For the quarter ended March 31st, net investment income was $0.18 per share including $0.04 per share in other income. Despite the overall choppy market, NAV was resilient and decreased by only 0.6%. The exit of Pivot was the primary reason the portfolio shrunk by $231 million during the quarter and our leverage ratio debt-to-equity went from 1.2x down to 0.8x. Over the last couple years, we've been targeting the reduction of the equity portion of our portfolio and using the cash proceeds to invest in loans to increase net investment income. At its peak, equity was 36% of the portfolio on March 31, 2021.

The percentage of our portfolio and equity as of March 31, 2022 was down to 25%. Our long-term target continues to be 10%. With regard to net investment income, we continue to have a strategy, which includes: #1, optimizing the portfolio and balance sheet of PNNT as we move towards our target leverage ratio of 1.25x debt-to-equity; #2, growing our PSLF JV with Pantheon to about $750 million of assets from approximately $450 million of assets; and #3, the opportunity to rotate out of our equity investments over time and 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 successful 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 technology. These sectors have also been resilient and tend to generate strong free cash flow. As an aside, government services and defense was approximately 11.3% of the portfolio inclusive of the JV and should be a beneficiary of the geopolitical environment. In many cases, we are typically part of the first institutional capital into a company where a founder, entrepreneur or family is 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 private equity firm to significantly grow the company to add-on acquisitions or organic growth. The loans that we provide are important strategic capital that fuels the growth and helps 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 co-investments have been excellent over time. Overall for our platform from inception through March 31, our $324 million of equity co-invest have generated an IRR of 28% and the multiple on invested capital of 2.7 times. Because we are an important strategic lending partner, the process and the 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 upfront fees and 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, virtually all of our originated personally loans had meaningful covenants, which help protect our capital. This is one reason why our default rate and performance during COVID was so strong. This sector of the market companies with $10 million to $50 million of EBITDA is the core middle market. As we just highlighted, within the core middle market we think our capital can add the most value and where we get the strongest package of risk and return is in the $10 million to $30 million of EBITDA range. Our track record at PennantPark has been excellent for 15 years, but it took a step up and improved as we increased our focus on this portion of the market starting in 2015. The IRR of our investments made prior to 2015 was 9.7%. Since 2015, we have achieved a 13.7% IRR. The core middle market is below the threshold and does not compete with a broadly syndicated loan or high yield markets.

As many of you know, there's been an enormous amount of capital raised by some of our large peers and as such, they are forced to focus on the upper middle market, which are companies with over $50 million of EBITDA. Those upper middle market companies can typically also efficiently access the broadly syndicated loan market. As a result, in the upper middle market, our large peers need to aggressively compete with the broadly syndicated loan market and among themselves. This results in transactions where leverage is high, covenants are light or non-existent, spreads and upfront fees are compressed and decisions need to be made quickly. Additionally, from a monitoring perspective, we only receive financial statements quarterly. The argument you'll hear is that bigger companies are less risky. That is a perception and may make some intuitive sense, but the reality is quite different.

According to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate and a 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 entire monitoring have been an important part of this differentiated performance. Our portfolio performance remains strong. As of March 31, our average debt to EBITDA in the portfolio was 5.1x and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.1x. This provides significant cushion to support stable investment income even when interest rates rise. We have 1 non-accrual on our book in PNNT and PSLF. This represents 3.5% of the portfolio at cost and 2.8% at market value. The last time PNNT had a non-accrual was December 2020.

Since inception, PNNT has invested $6.8 billion at an average yield of 11%. This compares to a loss ratio of about 10 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 RAM Energy, following a record 2021, the company continues to benefit from higher commodity prices. RAM recently drilled and completed 2 new wells. We are encouraged by the early flow back production results. As we anticipated, given the location of these wells, production is far more liquid rich than prior wells RAM has drilled in this acreage. RAM expects to complete flow back procedures and report results to the Texas Railway Commission in May. With regard to the outlook, new loans in our target market are attractive with our experienced talented and growing team, our large origination funnel is producing active deal flow.

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

Thank you, Art. For the quarter ended March 31, net investment income totaled $0.18 per share, including $0.04 per share of other income. Looking at some of the expense categories. Base management fee totaled $5 million. Taxes, general and administrative expenses totaled $1.2 million. And interest expense totaled $6.5 million. Net realized and unrealized change on investments net of any associated tax provision was a loss of $8.7 million or $0.13 per share. We redeemed a portion of our SBA debenture, which resulted in a realized loss from debt extinguishment of $1.1 million or $0.02 per share. Change in the value of our credit facility increased our NAV by $0.02 per share. Our net investment income was in excess of our dividend by $0.04 per share. We repurchased about 900,000 shares this quarter for under NAV, adding $0.03 per share. Consequently, NAV per share went from $10.11 per share to $10.05 per share, down 0.6% from the prior quarter.

As a reminder, our entire portfolio and credit facility are marked to market on ASC 820 and 825. Our Board of Directors each quarter using the exit price provided by independent valuation firms, security exchanges, independent broker-dealer quotes when active markets are available. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value their investments. Our GAAP debt to equity ratio, net of cash was 0.8x. Our overall debt portfolio has a weighted average yield of 8.4%. On March 31, our portfolio consisted of 113 companies across 30 different industries. Portfolio was invested 55% in first lien secured debt, 11% in second lien secured debt, 9% in subordinated debt including 6% in PSLF and 25% in preferred and common equity, including 4% in PSLF. 99% of the debt portfolio is floating rate, all of which has a LIBOR floor. Average LIBOR floor is 1%.

Now let me turn the call back to Art.

Thanks, Richard. 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 and we capture that free cash flow primarily in debt instruments and pay out those contractual cash flows in the form of dividends to our shareholders. In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your continued investment and confidence in us. That concludes our remarks.

At this time, I would like to open up the call to questions.

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

I'd just like to ask about the joint venture and just the decision to put a little bit more capital into the JV this quarter. I'm assuming that obviously came out of the proceeds from the large exits this quarter and maybe just also talk a little bit about the deal opportunity set between the JV versus what goes on to the balance sheet, any differences in those 2 and if you're seeing 1 market more attractive than the other.

Yes. So our deal flow does generally get allocated. The JV is a mechanism for us to enhance ROE through kind of leverage. So it's obviously mostly senior first lien loans that go into that vehicle. Equity co-invest does not go into that vehicle so the equity co-invest stays with PNNT. So the joint venture with Pantheon takes just the first lien deals very diversified. As we said, we did a CLO securitization financing in the joint venture this past quarter, which is really attractive long-term efficient financing and allows us to leverage the junior capital really nicely and in a safe way.

So kind of the goal there is to take the joint venture up to about $750 million of total assets, which should be a nice enhancer to the NII of PNNT given that it's a little bit more levered than what we're doing over at the BDC itself and of course the co-invest stick with the BDC. So nice tool for us, helps us write bigger checks to these companies so that we can fuel their growth and can be very efficiently financed. Track record so far has been very good. We're pleased with and I think Pantheon is pleased otherwise they wouldn't have been willing to put additional capital in. So again PNNT is about 60% of the capital and Pantheon is about 40% of the capital and they're pleased so far with the performance and they're willing to continue to invest in it.

That's been a great investment for your guys and I think a pretty good way to deploy at the moment. My other question, I'm hoping that you can maybe just quickly go over the non-core investment this quarter JF Holdings I believe that's mid-ocean. What exactly is that business and I guess what's kind of going on there? Any sort of update?

Yes. So the non-accrual is a company called Cascade Environmental, which does environmental drilling of soil. It did get impacted by COVID as drilling crews couldn't do their work and governmental entities who are a big chunk of their customers pushed things off. So there was work to do there, it just got delayed and deferred and Omicron did not help that company either. So there's a refinancing going on to refinance that capital structure. Our security is a -- has become a junior capital security more of a preferred stock. The idea is to set the company up with a capital structure so that it can now kind of grow reasonably well post-COVID. And of course we hope to and the sponsor hopes to look for an exit hopefully in the next year or 2. So it's been about 18 months since we had a non-accrual so it's the first one we've had in a while. Obviously we're not thrilled with it, but we are optimistic that over time we can get an exit.

Got it. Appreciate that and I also appreciate that your credit performance has been pretty good and there has not been many non-accruals in the recent past. Just few more if I can. As far as write-downs in this quarter just the net depreciation, how much of that reflected just kind of marking to market on loan prices during the quarter to more just sort idiosyncratic write-downs this quarter?

Yes. So there was a little bit of diminution in overall pricing for loans of course and the independent valuation firms certainly take overall market choppiness into account and then they layer that on top of the idiosyncratic individual name by name performance and come up with a blend of the 2. We had a substantial markup in RAM Energy, PT wasn't fully marked, Pivot Physical Therapy was not fully marked the last time so we had additional markup there as that worked towards exit. And then the markdowns were Cascade, Jones & Frank which you just alluded to and Cano. Cano of course is a public stock and that's been volatile. So those were the big movers both plus and minus in the portfolio from last quarter.

Got it. Last question, kind of a technical one. In the filing, you give some of the abbreviated financials for RAM Energy and I know that investment had a pretty nice markup this quarter. But I'm curious, I believe you gave the first quarter financials. What is the reason for the company being, I guess, profit negative this year whereas I think if the understanding is performance has been pretty good through last year seems to be things going pretty well this year so far. So what is the reason for just the negative profitability in this quarter?

Well, I think certainly drilling is an expense -- is the biggest expense. So as you know, we drilled 2 wells. So you put -- let's say hypothetically you put $20 million into drilling into the ground and then you hope -- and I think the numbers are panning out, you hope for good cash flow back from that. So just the nature of the business, you put something out and you make your wells and then you hopefully get the cash back in a lot more. So wells seem to be in reasonable shape, they seem to be kind of in line with the general performance of the rest of the geography and we're more encouraged early days about the performance of those wells.

And our next question will come from Robert Dodd with Raymond James.

Nice simple one for you. Considerable proceeds obviously from the very successful exit of Pivot, leverage went down, you have a lot of excess liquidity. How long do you think it's going to take you to get back closer to where you were on leverage previously? Obviously this time it would be with income producing assets, which could have a significant benefit on NII quite apart from the whole [vacant part]. So just what's -- I was kidding with an easy question, but here you go.

Because Robert, we know exactly our origination flow into the future. It's a science. I'm only kidding. Look, part of it's going to be kind of this market that we have in 2022 like are we -- I mean, we could in some sense, get lucky by, this might sound weird, but if our capital becomes more dear to companies, we might be able to deploy quicker at better risk adjusted returns in a choppy market, right? So we might have been lucky rather than smart to be super liquid today and have the market come our direction and have higher yields and lower risk in which case we could deploy sooner.

So far we're not seeing that, but we're only a couple -- few weeks into this kind of choppier market. So on a more normal basis, I'd say kind, I don't know, 6 to 12 months.

Kind of ramping several hundred million dollars would be a 6 to 12 month kind of thing and of course we're getting repayments along the way too. That's what happens when you pick good credits, which we never complain about. So I'd say in a normal basis 6 months, maybe a little bit more, might be 9, 12 months depends. Is deal flow going to slow up because of the choppiness or are we just going to get a lot of deal flow at better risk adjusted returns? We don't really know the answers to these questions yet. It certainly feels good to be liquid right now in an environment that looks different than it was 3 or 6 months ago. But as always it's deal by deal, name by name, good deal comes -- good pitch comes across the play, we're going to swing. And that's how you develop these portfolios. It's hard for us to make really macro projections.

I understand and I appreciate that. I mean, just sort of related. I mean on the deal flow that maybe deal memos coming across the desk, et cetera. I mean, it's unfair to compare today to 3 months -- well, like 3 months ago wasn't 2022, but to the end of 2021, that was obviously -- that was a crazy period. But I mean is the -- are the number of new memos coming to you depressed or has there been -- or were they depressed and they're starting to ramp back up? I mean anything on that?

So 2021 was crazy, particularly the end of 2021 was crazy. I think everyone in our business was exhausted and burnt out. In some ways thankfully the first quarter was light and I think it's normalizing right now. So we are -- I'd say we're kind of looking at a 2019 type pace pre-COVID for our business. We have invested in our origination platform and we have 5 offices across the United States. We keep investing in the team. So today we're now covering actively over 600 middle market financial sponsors. That's probably up 200 or 300 over the pre-COVID period.

So we've invested in that team, in those offices and in relationships so that we can get more looks. The idea is to get the looks and then you have to figure out do you like what you're seeing or not, but I'd say as a firm we're getting more looks, our origination platform's broader and deeper. We were deeper in the regions where we have the 5 offices and elsewhere. So the platform feels like it's good and it feels like if we really wanted to ramp, we can do that. Of course we need to make sure we ramp in a way where the quality is high. And that's the key and the trick in our business is to make sure the quality is high as you're ramping.

Understood. I appreciate and again congratulations on the quarter and the shape of the business and being liquid right now.

And our next question will come from Mickey Schleien with Ladenburg.

Just a couple questions for me. Art, we've talked about RAM Energy obviously a lot in the past. So my question today is simply what do you think it's going take for M&A in the oil and gas sector to pick up and potentially more positively impact RAM's valuation? Is it a situation where folks are just gun shy and they don't believe these prices are sustainable or what's holding things back?

It's a great question. We are -- right now there is not a middle market M&A way for oil and gas. We are starting to see some small trades not too far from our geography, which is promising. So that's point #1. Point #2 is you're still in a timeframe where if you're a seller, you still are modeling USD100 and USD7 or USD8 gas and if you're a buyer, you're thinking you should be buying USD70 and USD4 or USD5 gas, right? So there's still a gap over time that will collapse and will be an equilibrium. And I want to be clear here at PennantPark, we're not holding out for the last nickel or dime to sell RAM. We would want an efficient process, a process that is a good process that gets fair value.

So as soon as it makes sense and as soon as there is a bit of an M&A activity where buyers and sellers are coming together in a reasonable timeframe, we will kind of just start to assess options.

We're not quite there yet. In the meantime, we're heads down focused on completing these wells and optimizing the output and getting ourselves organized and getting the numbers put together and getting the engineering reports and setting ourselves up to have hopefully interesting conversations in the not too distant future. So we'd still look to, to get out in a reasonable timeframe at a fair price and in the meantime as long as you can make good investments kind of in wells and get good returns, that's not a bad backup strategy. It's not our top strategy, but not a bad backup strategy if things don't go the way we'd like.

That's really helpful. In the past you've talked about that RAM has a loan from the federal government, I think it was under the Main Street Lending Program and there's a potential I guess to refinance that and maybe liberate some cash up to Pennant. Is that still in the cards or given where the markets are, that's completely off the table?

That's possible. I mean, I think again we want to kind of execute on these wells, get the cash flow and it's possible that towards the end of the year we might be able to take it out. Again all these processes may come together where we're evaluating strategic options, we're evaluating our financing options. And we hope to have enough cash kind of in the till towards the end of the year to potentially refinance that, take it out. And yes, that would be 1 avenue for liberating -- as you say, liberating cash for PNNT shareholders.

Okay. That would be great. Just last question, sort of housekeeping maybe for Richard. Where does the Pivot exit leave the fund in terms of undistributed net capital gains if any on a tax basis?

We don't -- we're in a net capital loss situation from a tax basis even with the Pivot transaction. So we do have $0.52 for share of spillback.

Did you say 52?

52, correct.

And our next question will come from Melissa Wedel with JPMorgan.

You've actually answered a lot of mine already. But I was hoping to just get your thoughts at a high level about the volatility that we've seen in the forward curve and how you're thinking about both your portfolio investments, but also the broader market and what trade off there might be between sort of higher investment income from those floating rates moving higher and what offset there could be on the credit side of things and company's ability to really digest those borrowing costs.

Great question. And it's something we all need to be modeling in even more so in the coming environment, company's ability to weather higher interest rates. As I said, the average EBITDA to interest ratio we have today is 3.1x at PNNT. So I think we feel pretty good that even if rates go up, at PNNT we've got substantial cushion. That said, your point's an excellent one. I think we have to take it even more seriously into modeling and projecting going forward in our cases and investment committee memos higher interest rates. It would lead you to -- could lead you to which I think we've always had this discipline of keeping our leverage levels reasonable.

Here in this portfolio, we're about 5.1x debt to EBITDA. That's a comfortable zone for us. We don't like high debt to EBITDA multiples because it's just more burden that the company has to bear. So we are still oriented to cash flow. We're still oriented to free cash flow and getting paid down. I mean there's a lot of other people who are doing deals based on recurring revenues where there's not EBITDA and those have worked so far. But we are certainly in choppier waters and we need to maintain our prudency and maybe even double down on that in this choppier environment.

Art, do you think that that could impact the opportunity set for you too? Is there a -- I know the portfolio is almost essentially nearly entirely floating rate if there's demand from companies to lock in some financing costs at fixed rate, but perhaps at better spread. Is that something that your team would be thinking about?

Sure. I mean, look, we like to think we're economically rational as we like to think. I believe we are the vast majority of the time. But yes, if there's a -- like when we started out 15 years ago, Melissa, we did kind of lot of mezzanine debt, which was and still is, not that there's a lot of it going on, fixed rate kind of teens type of capital. So for the right credits, for the right structure, the right call protection, the right co-invest package, the right covenant package, we should be willing to trade that off. We don't come at it with an absolute view that we don't do fixed rate. With the right set of circumstances, I think we we'd be open to that.

Are you seeing demand from that from borrowers yet?

Not yet. I mean there might be a deal or 2 kind of in our pipeline that looks like that kind of what we would call traditional mezz. But it could come back, you're right. In this environment, there might be more demand for kind of back to the future kind of structures. We've had a good -- we know what we're doing in that world and got a good track record. So again opportunistically and in PNNT, this would be the place to do that versus PFLT opportunistically for the right kind of teens return, we would be open to that.

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

Thanks, everybody, for listening in today. We appreciate your focus on us. Our next quarterly earnings will be in early August and we look forward to speaking with you then.

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