PennantPark Floating Rate Capital Ltd. (PFLT) Q3 2017 Earnings Report, Transcript and Summary

Good morning, everyone, and welcome to the PennantPark Floating Rate Capital's Third Fiscal Quarter 2017 Earnings Conference Call. Today's conference is being recorded. At this time, all participants have been placed in a listen-only mode. The call will be open for a question-and-answer session following the speakers' remarks. [Operator Instructions] It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Floating Rate Capital. Mr. Penn, you may begin.

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

Thanks, Aviv. I'm going to spend a few minutes discussing current market conditions, followed by a discussion of the portfolio, investment activity, the financials, and then open it up for Q&A. As you all know, the economic signals have been moderately positive, with regard to the more liquid capital markets, and in particular, the leveraged loan and high yield markets. During the quarter ended June 30, those markets experienced strength, as high-yield and leveraged loan funds saw inflows due to a belief in a stronger economy and a benign interest rate environment. The overall market has strengthened and remains attractive, as debt investors and lenders, a flat economy is fine as long as we've underwritten capital structures prudently. A healthy current coupon with deleveraging from free cash flow over time is a favorable outcome for us. We remain primarily focused on long-term value and making investments that will perform well over several years and can withstand different business cycles. Our focus continues to be on companies and structures that are more defensive, have low leverage, strong covenants and high returns. As credit investors, one of our primary goals is preservation of capital. As we preserve capital, usually the upside takes care of itself. As a business, one of our primary goals is building long-term trust. Our focus is on building long-term trust with our portfolio companies, management teams, financial sponsors, intermediaries, our credit providers and, of course, our shareholders. We are a first call for middle-market financial sponsors, management teams and intermediaries who want consistent, credible capital. As an independent provider, free of conflicts or affiliations, we have become a trusted financing partner for our clients. Since inception, PennantPark entities have financed the companies, backed by 181 different financial sponsors. We are pleased that we've been approaching this investing market with substantially more capital and resources in order to drive significantly enhanced self-originated deal flow. This enhanced deal flow has meant that we can get more looks [ph] and be even more relevant to our borrower clients. Being more relevant means that we can be increasingly selective about which investments we make, as well as giving us the ability to be an important leader in transactions, who can drive terms. We have taken several steps in order to build this increased relevance over the last 2 years, including the MCG Capital merger, the addition of senior and mid-level professionals across different geographies, a follow-on equity offering, and last quarter the launching of PennantPark Senior Secured Loan Fund or PSSL. PSSL is our joint venture with Trinity Universal Insurance Company, a subsidiary of Kemper Corporation. We have a long-standing working relationship with Kemper, and are happy to expand our strategic partnership. We've started seeding the portfolio with a $36 million investment and are on our way towards ramping up that vehicle with our total commitment of $87.5 million. PSSL is not consolidated into PFLT and has already started borrowing on its way towards up to approximately $200 million of borrowing from third-party lenders led by Capital One. Similar to PFLT, PSSL will invest primarily in senior secured loans for companies that are more defensive, have low leverage and strong covenants. We expect the ROE on our overall investments in PSSL to be in the low to mid-teens, which should be accretive to PFLT and increase the net investment income over time. Although PFLT's investment in PSSL is considered as a non-qualifying asset, we still have plenty of cushion since only 10% of the maximum 30% basket is currently non-qualifying. Over time, we may consider a second senior loan joint venture. PSSL has the additional benefit, that PFLT and PSSL together can write larger checks for our sponsor clients and be more relevant to them, driving enhanced deal flow and better terms. For the quarter ended June 30, we have been active and are well positioned. We invested $137 million in primarily first lien senior secured assets, at an average yield of 8.3%. PSSL also invested $71 million in first lien senior secured assets at an average yield of 6.7%. Combined purchases were $208 million at an average yield of 7.9%. Core net investment income was $0.27 per share. Our debt-to-equity ratio is 0.64 times. After quarter end, we were awarded approximately $0.14 per share in a litigation settlement related to a former portfolio company of MCG Capital. We have significant spillover income that we can use as a cushion to protect our dividend while we ramp the portfolio. As of September 30, our spillover was $0.38 per share. As a result of our focus on high-quality companies, seniority in the capital structure, floating-rate assets and continuing diversification, our portfolio is constructed to withstand market and economic volatility. The cash interest coverage ratio, the amount by which EBITDA or cash flow exceeds cash interest expense, continues to be a healthy 3.4 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt to EBITDA on the overall portfolio was 3.9 times, another indication of prudent risk. Our credit quality since inception six years ago has been excellent. Out of nearly 300 companies in which we have invested, we have experienced only five nonaccruals. On those five nonaccruals, we have recovered $1.05 on the dollar so far. On June 30, we had one nonaccrual on our books, representing 0.4% of the portfolio on a cost basis and 0.2% on a market-value basis. In terms of new investments, we had another active quarter, investing at attractive risk-adjusted returns. Our activity was driven by a mixture of M&A deals, growth financings and re-financings. In virtually all these investments, we have known these particular companies for a while, have studied the industries, or have a strong relationship with the sponsor. Let's walk through some of the highlights. We invested $12 million in the first lien debt of BEI Precision Systems & Space. BEI is a provider of positioning sensor solutions including optical encoders, micro-scanners, and accelerometers. J.F. Lehman is the sponsor. By Light Professional IT Services is a provider of IT services to the government. We purchased $26 million of first lien term loan and $2 million of equity. Sagewind Capital is the sponsor. We lent $12 million of first lien term loan to Hollander Sleep Products, which produces and sells bedding products. Sentinel Capital is the sponsor. LSF9 Atlantis or [A Wireless] [ph] is a leading exclusive independent retailer for Verizon Wireless. We invested $20 million in the first lien term loan. Lone Star Capital is the sponsor. Turning to the outlook, we believe that the remainder of 2017 will continue to be active due to both growth and M&A driven financings. Due to our strong sourcing network and client relationships, we are seeing active deal flow. Let me now turn the call over to Aviv, our CFO, to take it through financial results.

Thank you, Art. For the quarter ended June 30, 2017, core net investment income was $0.27 per share. Looking at some of the expense categories, management fees totaled $3.2 million, general and administrative expenses totaled about $1.2 million, and interest expense totaled about $2.5 million. Core net investment income does not include $0.02 per share of accrued, but not payable, incentive fees on realized and unrealized gains. During the quarter ended June 30, net unrealized appreciation on investments was about $500,000 or $0.02 per share. Net realized gains was $2.5 million or $0.07 per share. Net unrealized appreciation on our credit facility was $2 million or $0.06 per share. And dividends in excess of income was $1 million or $0.03 per share. Consequently, NAV remained flat at $14.05 per share. Our entire portfolio and our credit facility are mark-to-market by our Board of Directors each quarter using the exit price provided by independent valuation firms or independent broker/dealer quotations when active markets are available under ASC 820 and 825. In cases where broker/dealer quotes are inactive, we use independent valuation firms to value the investments. Our portfolio is relatively low risk. It is highly diversified, with 86 companies across 24 different industries. 88% is invested in first lien senior secured debt, 4% in second lien debt, 5% in subordinated debt and 3% in equity. Our investment in PSSL, whose underlying investments are first lien senior secured loans, represents about 70% of the subordinated debt and equity investments in PFLT's portfolio. Our overall debt portfolio has a weighted average yield of 8.2%. 99% of the portfolio is floating rate. Now, let me turn the call back to Art.

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is a steady, stable and protected dividend stream, coupled with the preservation of capital. Everything we do is aligned with that goal. We try to find less risky middle-market companies that have high free cash flow conversion. We capture that free cash flow primarily in first lien senior secured floating rate debt instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders. In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your investment and confidence in us. That concludes our remarks. At this time, I'd like to open up the call to questions.

Thank you. [Operator Instructions] And we'll go first to Ryan Lynch with KBW.

Good morning. Thank you for taking my questions. The first one just has to do with the growth at the joint venture of PSSL. I believe, the majority or actually all of the growth during this quarter was from - in the joint venture, was from dropping down assets off PFLT's balance sheet into the joint venture. And so, as we look at that going forward, I mean, assuming that that most of the transactions from [center float's] [ph] balance sheet that you wanted to drop down have been dropped down. So going forward, how should we think about growth in the JV over the next few quarters?

Thanks, Ryan. The growth will be driven primarily, going forward, with new transactions that we originate, where PFLT will - itself will take the vast majority of it, and a bite size that's reasonable and fits the JV will take a minority piece of it. So think of it as PFLT taking $29 million bites or so and JV taking $5 million to $7 million bites.

Okay. And then, as you mentioned, PFLT's balance sheet as well as the joint venture, given that access - the additional capital of the joint venture that's increasing your relevance across sponsors. Can you just talk about what that means? Are you guys getting access to additional deal flow that you guys weren't before? Can you guys now - are you guys looking to invest in larger companies potentially with bigger deal sizes or are you guys now able to lead more transactions versus buying into - clubbing up with other folks? Can you just talk about what you guys increasing size means?

Sure. So look, our core market is financial sponsors, middle-market financial sponsors. Where we add the most value is with companies that do between $10 million and $30 million of EBITDA. Once you get kind of $40 million and above, typically there is much more pressure from the broadly syndicated market, in certain cases, those companies do hit the broadly syndicated market. In certain cases, the tone from the broadly syndicated market seeps down into those $40 million, $45 million, even then occasionally $35 million EBITDA companies. So right now, our kind of target market is no market sponsors, companies that do $10 million to $30 million of EBITDA and what as - one of the big drivers of our mission on PFLT is our sponsored clients have been saying to us, gee, we wish you could do a bit - do more, we wish you could help drive our deals, we'd love to allocate more to you, we'd love to give more to you, can you do more than $10 million, $15 million, $20 million, $25 million whatever the number is, as PFLT has grown. And the steps we've taken with MCG, with adding talent in the regions, with the add-on equity offering we did with the JV itself is really just meeting the mission and meeting the ask of our clients. We want to serve those financial clients, assuming we can get really good risk reward. Obviously, that's a given. We want to be a problem solver for them, so they've been the ones driving us to do this. Obviously, we need to do it in an accretive way for PFLT shareholders and we think we can do that, we think the JV really helps us do that, and we may end up doing a second JV down the road. And occasionally, there's co-investments between PFLT, obviously the JV, PNNT, sometimes it meets the mission of that vehicle. We have a credit opportunity fund, sometimes it meets the mission of that vehicle. So between all of our vehicles, we can write some pretty big bite-sizes overall, but we didn't want to maintain really rational, granular diversification on all of these portfolios. PFLT is massively diversified. We want to keep it massively diversified. The JV is massively diversified. We like that safety from the standpoint of diversification. So we think it can be a win, win, win for our shareholders, of course, for our borrower clients, of course, we think you can - this market where we're in, where it's $10 million to $30 million of EBITDA, we think we're in a really good spot.

Okay. That's helpful commentary. And then, just one last one. You mentioned potentially another JV down the road. I know, you guys are still probably hyper focused on the first JV in ramping that up. And I know there is some execution that has to be done there, but are you guys in talks or looking at different partners for a second JV? I know that process probably takes a little bit, or is that just, is that commentary more along the lines of we'll see how this first JV goes, and if this first JV starts to execute well, then we'll look to explore a second JV?

Sure. And it's a good question. It's a little bit of both. I mean, obviously we need to put our head down and execute JV one well. We need to find good deals. We need to ramp the portfolio judiciously and prudently. At the same time, there are both equity providers, equity partners as well as lenders who've approached us, from time to time, to partner with them. I mean this technology obviously - we are a late arriver in the BDC space on these JVs that are now, I don't know, six, seven, eight years old. We think for PFLT, it makes a lot of sense we have to prove now to ourselves and to the marketplace, but we would certainly be open to a second JV over time, as we hopefully execute well on JV one. And we've been approached by parties to be partners, both on the equity side and the lending side.

Okay. That's great. Thank you for taking my questions.

Thank you.

And we'll take our next question from Doug Mewhirter with SunTrust.

Hi, good morning. I had a question about the yield. If you calculate your portfolio yield overall in the quarters, there was a nice sequential uptick. As well as the nature of that, was there a lot of - was there some call protection on exits that you got? Was it just getting better yield? Was it a dividend payment that might have slipped in there? And also what's - and I guess the second part of my question is what's the yield versus - of investments you're bringing on versus the investments that are rolling off as well?

Yes. So it depends how you look at it, Doug. It's a good question. On a blended basis, if you include both PFLT and itself - and then the JV, it blends about 7.9%, which is actually, I think pretty, consistent. We have been hovering upper 7%s, low 8%s, for a long time and interestingly, we said, hey, the deals that went in this JV are lower-yielding deals. And that's a little bit of self-selection because if we are going to get more than one-to-one leverage, which we are in the JV, you want to have some lower risk deals in there. Certainly, we do, and our partners do. So the JV, the average yield on the deal's net portfolio were 6.7% whereas, the average yield on the deals that were PFLT were 8.3% blending to 7.9%. So it's an interesting, interesting market we are in. I guess we just found some interesting deals this quarter. We highlighted some of the highlights, whether it's the BEI deal or the By Light or Hollander, they had - they were again in this $10 million to $30 million of EBITDA range, where you have a lot less pressure from the broadly syndicated space. Where our relationship matters, where we could drive a deal and drive terms, including the yield and the covenants and all of that. So we just had a nice quarter from that standpoint. It's a lumpy business, I don't have any scientific explanation other than that.

Okay, thanks. That's very helpful. And that's all my question.

Thank you.

And we'll take our next question from Mickey Schleien with Ladenburg Investment Bank.

Yes, Art, I just wanted to follow-up on that last question, because I'm not sure you addressed the fee income in the quarter. Was there any nonrecurring fees or dividends or prepayments? Because I agree, I see interest income was up 14% quarter-to-quarter, but the portfolio contracted so something needs to fill that difference?

Yes. No, we had this - as you know, Mickey, on our company's web, this line called other income, which is prepayment penalties, it's amended fees occasionally. We have $0.01 this quarter on the other income, which is relatively low for PFLT. Typically, it's a little bit more than that. So it's just the idiosyncratic nature of what got paid off this quarter, it's kind of related to that $0.01, and in many quarters it's more than $0.01. Now next quarter there'll be this subsequent event. We had to - we won this law - we settled this lawsuit for $0.14, that'll be $0.14 a share of other income so next quarter that other income line will be much larger than it was this quarter. So that's lumpy.

Actually, that's my next question. Just to confirm, that's about $4.6 million, is that correct?

That's right. Yes.

And are you - I have a question in terms of accruing for that settlement, and when you will receive the cash, and will you be earning an incentive fee on that also?

Yes, so that's - that will be cash. And we think it's getting paid at the end of September. Correct? So we think we're getting cash in September, and this is the second settlement we've had. This is due to the Color Star litigation that we inherited from MCG. We had a settlement of something like $3 million a year or two ago, and this was like over $4 million. So this ended - I mean, this is the final piece of that litigation and last time and this time we counted as other income. It goes in the other income line, and then the calculation is wherever the calculation is on fees.

Okay, and just a few questions about the senior loan fund. I couldn't find the terms on the subordinated notes. Could you just give that to us? And how much did you accrue into PFLT's interest income from those notes?

So the terms are on the SOIs, with a LIBOR plus 500 or something?

Yes, it's something like that and it's two-thirds of our investment, two-thirds in subordinated notes and one-third of our investment is in equity of the PSSL. So it's on our SOI, we show it straight on the SOI as what PFLT is accruing up subordinated notes.

And it's a big toggle. If there's cash, it pays cash otherwise - and otherwise it's accrued.

That's correct. Yes, right. And just following up on the balance sheet, if I add those notes in the line of credit. I know it's sort of a stub period but debt-to-equity in June was 4 times, which sounds very high. So can you just walk us through the balance sheet and how that's going to progress over the next few quarters?

And if are you talking about which balance sheet, Mickey? The PFLT balance sheet?

Yes, the senior loan funds balance sheet.

I think as of June 30, it was probably closer to one-to-one, I don't have it right in front of me. As you bed these senior loans funds, you put in deals on a granular basis to get diversification. You put in your equity, you get kind of one-to-one leverage. And then once you get a certain amount in there, and it's a diversified portfolio with a certain amount of assets, that's when you start to get a little bit more leverage and where you can get the up to two-to-one over time. So we're just at about that pivot point right now, where the new deals that are coming in, we can get a little bit more than one-to-one leverage, but we can follow-up afterwards on the specifics.

And my last question. Just to confirm, the fund didn't upstream any dividends to PFLT, that's right?

Not yet.

Not yet. Could that happen in the coming quarter?

It could. We're going to see we're - the idea is, of course, to number one pay the subordinated debt instrument in cash. That's plus 500, that shouldn't be too hard. And then in every quarter we'll make an assessment as to what gets in our stream then we'll share with everybody. The goal on the overall capital for us is $87.5 million, two-thirds of which will be subordinated and then one-third will be equity as we think we're getting a low to mid-teens on that package of securities on those investments. So hopefully this is pretty substantial cash flow enough to PFLT as we ramp that portfolio.

Very good. I appreciate the time this morning. Thanks.

Thanks, Mickey.

And at this time, I would like to turn the conference back to Mr. Penn for any additional or closing remarks.

Thanks, everybody. I appreciate everyone's interest in participating today. Just to remind you, our next quarter is our 10-K quarter so it'll be a little bit later in the quarter when we do our earnings release and conference call, so targeting mid-November. So we look forward to speaking to you then and we look forward to speaking to you during the quarter as investors call us and we're happy to share what's going with PFLT and any of our vehicles. So thank you very much today - for participating today and we look forward to speak to you in the future.

Thank you. And that does conclude today's conference. Thank you for your participation. You may now disconnect.