PennantPark Floating Rate Capital Ltd. (PFLT) Q2 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the PennantPark Floating Rate Capital’s Second Fiscal Quarter 2018 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 your conference.

Thank you and good morning everyone. I would like to welcome you to PennantPark Floating Rate Capital’s second fiscal quarter 2018 earnings conference call. I am joined today by Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Thank you, Art. I would 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 would 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 www.pennantpark.com or call us at 212-905-1000. At this time, I would like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Thanks, Aviv. I am going to spend a few minutes discussing financial highlights, followed by a discussion of the portfolio, investment activity, the financials, and then open it up for Q&A. For the quarter ended March 31, we invested $138 million, primarily in first lien senior secured assets at an average yield of 7.8%. Since quarter-end through April 30th, we have purchased an additional $50 million of investments. PennantPark Senior Secured Loan Fund or PSSL continued to grow. As of March 31st, PSSL owned a $220 million diversified pool of 30 names, with an average yield of 7.6%. Since quarter-end through April 30th, PSSL invested in an additional $31 million of investments. Over the last several years, we’ve substantially grown our platform by adding senior and mid-level investment professionals in regional offices, as well as New York. The additional people and offices combined with the additional equity and debt capital we have raised have resulted in significantly enhanced deal flow. This puts us in a position to be both active and selective. The growth in our PFLT and PSSL portfolios are evidence of this enhanced platform. We are pleased to announce that we have doubled our PSSL joint venture with Kemper Insurance. In addition, Capital One in a syndicate of lenders has doubled the PSSL credit facility as well. As a result, PSSL has buying power of $630 million, consisting of a $420 million loan facility and $210 million of notes and equity. PSSL has enabled us to be even more responsive to our middle-market, private equity sponsor clients as well as generate an attractive ROE to help grow PFLT’s income. Net investment income was $0.24 per share. The vast majority of the investments made in PFLT and PSSL during the quarter ended March 31st were made late in the quarter. Our earnings stream should have a nice tailwind based on that activity, additional investments we’ve made since quarter-end, increases in LIBOR and the doubling of capacity in PSSL. As of September 30th, our spillover was $0.45 per share. In a surprise move on March 23rd, the Small Business Credit Availability Act was signed into law. On April 5th, the Board approved the modified asset coverage that was included in the new law reducing asset coverage from 200% to a 150%, effective April 5, 2019. The Company has generated an excellent track record over the last seven years investing in lower risk, first lien senior secured floating rate assets. We believe that such assets represent an appropriate risk profile that can be prudently leveraged under the revised statutes to provide attractive returns for our investors. Our successful operation of PSSL is evidenced of this strategy. Over the next year, we look forward to working closely with our lenders, bondholders, rating agencies and stockholders to discuss our roadmap into the future. Our primary business of financing middle-market financial sponsors has remained robust. We have relationships with about 400 private equity sponsors across the country and elsewhere that we manage from our offices in New York, Los Angeles, Chicago, Houston and London. We have done business with about 180 sponsors to date. Due to the wide funnel of deal flow that we receive relative to the size of our vehicles, we can be extremely selective about what we ultimately invest in. 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. We are 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’ve become a trusted financing partner for our clients. 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 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 lender in transactions who can drive terms. We’ve taken several steps in order to build this increased relevance over the last few years including the MCG capital merger, the addition of senior and mid-level professionals across different geographies, two follow-on equity offerings, launching of PSSL, our recent bond offering and now the doubling of PSSL. 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, continued to be a healthy 2.9 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt to EBITDA on the overall portfolio was 4.25 times, another indication of prudent risk. Our credit quality since inception over seven years goes has been excellent. Out of 320 companies in which we have invested, we have experienced only five nonaccruals. On those five non-accruals, we’ve recovered $1.05 on the $1 so far. At March 31, we had one nonaccrual on our books, representing 0.3% of the portfolio on a cost basis and 0.1% on a market value basis. In terms of new investments, we had another active quarter investing in attractive risk-adjusted returns. Our activity was driven by mixture of M&A deals, growth financings, and refinancings. And virtually all these investments, we’ve 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 highlights. We invested $14.7 million in the first lien debt of Beauty Industry Group. Beauty Industry Group provides hair extension and cosmetic products. Gauge Capital is the sponsor. Credit Infonet is a software company focused on the bankruptcy market. We purchased $28 million of a first lien term loan. Sentinel Capital is the sponsor. We lent $14.3 million of first lien term loan to Douglas Products and Packaging. Douglas Products is a leading manufacturer and distributor of specialty chemicals for pest management, thermal fluids and sanitary sewer applications. Altamont Capital is the sponsor. We had $11.3 million to our existing first lien loan to Morphe. Morphe is a cosmetics company controlled by Summit Partners. Turning to the outlook. We believe that the remainder of 2018 will 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 you through the financial results.

Thank you, Art. For the quarter ended March 31, 2018, net investment income was $0.24 per share. Looking at some of the expense categories. Management fees totaled $2.3 million, general and administrative expenses totaled $1.1 million, and interest expense totaled about $3.5 million. During the quarter ended March 31st, net unrealized depreciation of investment was about $600,000 or $0.02 per share. Net realized gain was $1.5 million or $0.04 per share. Net unrealized appreciation on our credit facility and notes was $5.3 million or $0.14 per share. And dividend in excess of income was $1.7 million or $0.04 per share. Consequently, NAV went from $13.86 per share to $13.98 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 an independent valuation firm 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. 91% is invested in first lien senior secured debt, 4% in second lien debt, 5% in subordinated debt and equity including 3% [ph] in PSSL. Our overall debt portfolio has a weighted average yield of 8.6%. A 100% 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 to 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 would 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 would like to open up the call to questions.

[Operator Instructions] And we will take our first question from Doug Mewhirter with SunTrust. Please go ahead.

Hi. Good morning. I just have one question. Comparing your portfolio growth this quarter with your sister company PNNT, it seemed you had a lot more inflows, lot more growth at PFLT. And I realize that the funnel goes through the same underwriting organization. I was just wondering if that says anything about the current state of the market where first lien or the less risky loans seem to be more attractive to you overall or there is just of a lack of the draw [ph] this quarter and it could easily reverse itself and PNNT would have more growth next quarter just because that’s just the way the dates rolled or whatever?

It’s good question, Dough. Thank you. In both vehicles we’re prioritizing higher pieces in the capital stack, albeit PFLT as a lower yield threshold than PNNT. So, there was -- it is a lumpy business. So, number one, those trends could revert any quarter. On the other hand, of course it’s relatively easier to originate lower yielding safe investments in this marketplace. So, we like being senior in both vehicles. One vehicle has a lower hurdle in terms of budgets than the other. But we could see a big quarter again in PNNT next quarter or any other quarter, as well as continuing to see growth in PFLT. I mean, what’s happened is as we’ve grown our platform and as we’ve opened up these offices and added people, we have many, many more touch points with the middle market financial sponsors; we cover like 400 middle market financial sponsors. As I said, we’ve done business with 180. And every day because of the investment we’ve made in our team and in our infrastructure, we’re meeting and getting to know more and more of these potential clients of the firm. And as a result, we’re getting more looks which give us the benefit of being, as we say active and selective. And relative to the size of our capital, which is a medium-sized firm, we’re seeing a relatively good environment for us to find deals.

[Operator Instructions] And we’ll take our next question from Paul Johnson with KBW. Please go ahead.

Yes. Good morning, guys. Thanks for taking my question. I just have one question for you. I’m just curious, given that you’ve passed the asset coverage modification, do you have any different plans and how you plan to manage your sort of leverage as you go forward and approach that date next year?

Yes. So, it’s good question, Paul. We -- this whole law was obviously a surprise to us. We had already gone down the road of upsizing our PSSL joint venture which in and of itself has up two to one leverage. So, we had doubled our equity commitment from PFLT and Kemper doubled their commitment as well as doubling the credit facility from Capital One. So, we basically had that structure inked when we got word that this law changed. So, the upsizing of PSSL is going to be -- using that extra capacity over the next six to nine months is obviously a key priority for us. And we’ve got the Board approval just to give us the runway for 12 months. Hence as we evaluate all the different options, talk to our shareholders, talk to our bondholders, talk to our lenders and assess what exactly we’re going to do. But as we said -- and then, as we said for the last years is this law was being evaluated. We think the assets in PFLT could judiciously be leveraged more than one to one and still operate prudent risk-adjusted return for our shareholders. And certainly, our operation at PSSL would so far -- by the year-end, it has been very smooth. Our relationships with our lenders have been good. We doubled the credit facility in PSSL. We had an oversubscription; we had to cut lenders back. And I think that’s because lenders see, number one, the quality of the collateral that we have, first lien senior secured floating rate loans, and they also see that the track record over the last seven years that we’ve had investing in this asset class. So, should we decide in the coming months to go to more fulsome, up to two to one leverage, as an overall firm we’ve been operating at, we think it could prudently be done, and we do think we could get capital. We haven’t firmly make decision. So, we’ll keep everybody appraised along the way. We do want to hear from all of our stakeholders along the way. As this law has been [Technical Difficulty] the last 10 years, we’ve said to people, hey, we think these assets could prudently be leveraged more than one to one, and no one has disagreed with that, not a rating agency, not a bondholder, not a shareholder. So, we feel good about the support, should we decide to do it.

And the PSSL has been a very nice source of growth for you. I am curious, given that you just recently issued bonds in the Israeli market, are there any sort of covenants that we should know about as far as restrictions on the leverage limitation?

The biggest restriction is the rating. The biggest restriction there is a ratings grid, such that if we get a 2-notch downgrade, the coupon picks up 25 basis points and each notch thereafter another 25. We have had conversations with S&P Maalot, which is the S&P affiliate in Israel who has confirmed the Israeli rating. So, they firmed up the Israeli rating. There is notch down in the Israeli rating. So, we feel very good about that.

And we’ll take our next question from Mickey Schleien with Ladenburg. Please go ahead.

Good morning, Art and Aviv. I certainly appreciate your comments and I appreciate that PFLT was able to find good deals flow this quarter. I guess that’s a testament to your origination capability. But, Art, looking at the big picture, this is a market that’s got a lot of capital, and it’s no secret that terms are relatively loose and spreads have been compressing. So, given your background and your tenure in the market, you’ve seen cycles before. But, this seems to be different because we’re rebounding from such a deep recession 10 years ago, and there’s a lot of capital in the market. So, do you see anything, any catalysts in the near-term that could help bring the market more into equilibrium and make it more lender friendly?

Hello. Mr. Penn, you might be on mute. Hello, Mr. Penn. Can you please check your mute function? I believe you might be on mute, if you’re answering the question. [Operator Instructions] And you are live. Mr. Schleien, can you please repeat your question?

Hey, Art. Can you hear me?

Yes. Sorry about that. We had some technical difficulty. I think, we got your question, which was it feels like we’re at the peak of the credit cycle, what could end it, and how you’re thinking about, is that basically question?

Yes, essentially. You’ve seen cycles before. So, we would -- I think we would all appreciate your insight and thinking as to what could help bring the market more into equilibrium, notwithstanding the fact that PFLT has managed to originate deals at attractive risk-adjusted returns, but overall, the market seems pretty frothy. So, I’d be very interested in your views about that.

Yes. It’s a good question. We in 2015 said, we thought it was the peak of the credit cycle and we said that publicly.

Exactly.

So, that gives you the sense for what we know. This environment could last -- could last a few more years, it could at any moment turn around for any number of reasons. We underwrite as if it is the peak of the credit cycle. We do our downside case -- cases in our investment memos assuming a recession hits next year. We like where PFLT is. It’s kind of on average 4.25 times debt to EBITDA. On average, the yields are 7.5%. On average, the equity cushions from the financial sponsors are 40%, 50%. So, we’re underwriting as if we’re at the peak of the credit cycle. And due to our robust team, which we’ve invested in, we’re seeing relatively -- a nice deal flow, compared to the size of our vehicles. PFLT relative to our senior debt market in United States is small. Our deal teams are really senior. We’ve got nine people in the firm who have over 20 years of experience. So, our brand and our awareness in the market is actually greater than our capital at this point, which gives us an opportunity to be very selective and both active at the same time. But, Mickey, we underwrite as if it could turn any day and we were around ‘07 and in ‘08. And as we said in our comments, certainly yesterday in PNNT, we’ve been there and done that and during the global financial crisis we have mostly subordinated debt portfolio and our track record was very strong through that global financial crisis.

Art, just a follow-up then, given what you just said, and I know you tend to stay away from things like restaurants and fashion, but with that mindset in terms of underwriting as if a recession could be around the corner. Are there certain industries, other industries in sectors that you’re absolutely sitting -- you’re not going to get involved in with regards less of the terms that are offered to you?

Look, in PFLT, we’re staying away from energy [technical difficulty] and we’re going to stay away from energy in PFLT as well PNNT going forward. We tend to really want to match the dividend stream, which we’re hoping is steady, stable and hopefully growing. We want to match that with underlying cash flows of companies and industries that can generate steady, stable earnings streams. So, we’re looking at free cash flow conversion [technical difficulty] that would be business services or distribution or number of other different industries, software, a number of different industries where we think the cash flows are steady and stable.

That’s really helpful. That’s it for me. I appreciate your time this morning. Thank you.

Thank you. I do want to apologize to everybody for the technical difficulty and thanks for staying on the call through that. And with that, it doesn’t look like, there’s any question. So, thank you everybody for your participation in today’s call. We will talk to you next in early August after the filing of our next Q. Thank you very much.

Once again, that does conclude today’s conference. Thank you for your participation. You may now disconnect.