PennantPark Floating Rate Capital Ltd. (PFLT) Q3 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the PennantPark Floating Rate Capital's Third 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 third 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'm going to spend a few minutes discussing financial highlights followed by a discussion of the portfolio, investment activity, the financials, and then we'll open it up for Q&A. For the quarter ended June 30, we invested $165 million in primarily first lien senior secured assets at an average yield of 8.2%. The average yield of new investments has increased during 2018 and has benefited from recent increases in LIBOR. PennantPark Senior Secured Loan fund or PSSL continued to grow. As of June 30, PSSL owned a $347 million diversified pool of 38 names with an average yield of 7.7%. Again, the average yield on PSSL also benefited from LIBOR increases. Over the last several years, we have substantially grown our platform by adding senior and mid-level investment professional and regional offices as well as New York. The addition of people and offices combined with additional equity and debt capital raised has significantly enhanced our deal flow. This puts us in a position to be both active and selective. The growth is evidence of this enhanced platform. Debt investment income was $0.31 per share. Core net investment income which excludes accrued not payable incentive fee was $0.28 per share. Due to the activity level we are seeing, the increase in LIBOR and the growth of PSSL, we are pleased that our current run rate recurring net investment income covers our dividend. Our earning streams have a nice tailwind based on continuation of these factors. As of September 30, our spillover was $0.45 per share. With regard to the Small Business Credit Availability Act, a reminder that our Board approved the modified asset cover that was included in the law reducing asset coverage from 200% to 150% effective April 5, 2019. The company has generated an excellent track record over the last seven years, and they are seeing lower risk first lien senior secured floating rate assets. We believe that such assets represented appropriate risk profile that can be prudently leveraged under the revised statute to provide attractive returns for our investors. Our successful operation PSSL which is today operating at the reduced asset coverage level contemplated by the new law is evidence of this strategy. We continue to work closely with our lenders, bondholders, rating agencies and stock holders to discuss our road map into the future. We're pleased with the positive feedback we received from various stakeholders. 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, and we manage from our offices in New York, Los Angeles, Chicago, Houston and London. We've done business with about 180 sponsors to-date, and 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're only investing at about 2% of the deals that we are shown. We remain primarily focused on long-term value and making investments that will perform well over perform several years and can withstand different business cycles. Our focus continues to be on companies and structures that are more defensive at low leverage, strong covenants and high returns. 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'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 leader in transactions who can drive terms. 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 2.7 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt to EBITDA on the overall portfolio was 4.4 times, another indication of prudent risk. And our core market of companies with $15 million to 40 million of EBITDA, our capital is generally important to borrowers and sponsors, we're still seeing attractive risk reward and we're receiving covenants which help protect our capital. Our credit quality since inception over seven years ago has been excellent. Out of 325 companies, in which we have invested since inception, we have experienced only five non-accruals. On those five non-accruals, we've recovered $0.98 on $1 so far. As of June 30, we had no non-accruals on our books. With regard to economy and credit cycle, at this point, our underlying portfolio indicates a strong U.S. economy and no sign of a recession. Looking at our long-term track record, we believe that we're well positioned to weather different economic scenarios. From experience standpoint, we are one of a few middle market direct lenders who was in business prior to the global financial crisis and has a strong underwriting track record during that time. Although, PFLT was not in existence back then, PennantPark as an organization was and was focused primarily on investing in subordinated and mezzanine debt. Prior to the onset of global financial crisis in September 2008, we initiated investments which ultimately aggregated $480 million, again primarily in subordinated debt. During the recession, the weighted average EBITDA of those underlying portfolio companies declined by 7.2% at the trough of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%. As a result, the IRR on those underlying investments was 8%, even though they were done prior to the financial crisis and recession. We are proud of this downside case track record on primarily subordinated debt. In terms of new investments, we had another active quarter investing in attractive risk adjusted returns. Our activity was driven by a 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 $18.7 million in the first lien debt of Beauty Industry Group. Beauty Industry Group provides hair extension and cosmetic products. Gauge Capital is the sponsor. Impact Group provided outsourced sales, marketing and merchandising services to consumer packaged goods companies. We've purchased $20 million of a first lien term loan. CI capital is the sponsor. 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 June 30, 2018, net investment income was $0.31 per share, core net investment income was $0.28 per share excluding $0.03 per share of accrued but not payable incentive fee. Looking at some of the expense categories, management fees totaled $3.5 million, general and administrative expenses totaled about $1.1 million, and interest expense totaled about $3.9 million. During the quarter ended June 30, net unrealized depreciation on investment was about $30.2 million or $0.08 per share. Net realized losses was about $2 million or $0.05 per share. Net unrealized appreciation on our credit facility and notes was $2 million or $0.05 per share and income in excess of dividend was about $1 million or $0.02 per share. Consequently, NAV went from $13.98 per share to $13.82 per share. Our entire portfolio, our credit facility and notes are mark to market by our Board of Directors each quarter using the exit price provided by an independent valuation firm, exchanges or independent broker dealer quotes 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 high diversified with 89 companies across 22 different industries. 90% is invested in first lien senior secured debt, 4% in second lien debt, 6% in subordinated debt and equity including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 8.7%. 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] We will take our first question today from Ryan Lynch with KBW. Please go ahead.

You mentioned in your prepared comments that you guys have added PSSL to the platform that has kind of enhanced the deal flow. Can you maybe just highlight some of the recent hires you guys have made across the PennantPark slab platform and exactly what they are really bringing to the platform and the deal flow side?

I'm sorry, Ryan. I've been on mute. We've had –we've made investment in U.S. and outside the U.S. in senior people. We've added an office in Los Angeles and office in Chicago. One of our partners moved to Houston. We've added an office in London and we've beefed up senior and mid-level team here in New York. That has resulted in more looks, more relationships, new relationships coming into the firm. You know we decided as we were beefing up our overall business and our first lien business in particular, we would – that we needed to be a bit more feet on the street in order to get the looks and the relationships that we were hoping to get. So those investments which have been over the last few years had really started to tail up with new relationships and more looks and more deals than we've ever had.

I thought I stumped you there for a second.

We got some technical difficulties. My apologies.

No, it's fine. And then, moving to the some of the unrealized losses this quarter, were those driven by company, like I guess what really drove the depreciation or unrealized loss. I saw LifeCare had a little bit of mark. Were there any other specific companies that drew up the bulk of those write-downs?

Hey look, it was about – I think it was about $0.15 in total NAV diminution. You know two-thirds of it were things that are – number one, our bond has traded up. So, as you know our accounting basically, when our bonds trade up, that hurts our NAV, that's because we try to match assets and liability and how we mark to market. So, that was about a third of our NAV diminution. Another third of our NAV diminution was because we excited Sunshine Oilsands which was our one energy deal that we had. It was our one non-accrual that we had and we just decided to exit and not have any energy names, so we exited that. So, between the bonds being marked up, us exiting our one non-accrual and our one energy name, that's two-thirds of the NAV effect that we had, and then you know we have like one health care name LifeCare that continues to – the small investment that continues to be troubled. But we feel pretty good about the portfolio. Our – the company is by and large are performing well and as we said in our remarks, we see no signs of recession. So, we feel really good about the book.

You may have said this in the past, but I don't have it down anywhere. Have you guys provided any sort of with the passage of the increased leverage limitation, have you guys provided any sort of target leverage range you guys intend to run that once that goes into full effect?

Well, we have not provided that range yet whereas we said in our prepared remarks, we're speaking to you know all of our stakeholders and getting feedback, rating agencies, et cetera. Look, I mean if you look at PSSL as an example, that is leveraged more than 1, and we believe we have among the lowest risk book of any BDC if you look at the deals we're doing, primarily first lien. If you look at the yields that we're generating, which are among the lower end of the BDC space, which indicate among the lower risk of the BDC space, we feel comfortable that we can operate comfortably with cushion above the 1 to 1. But, over the coming months, we'll be pertaining and then deciding and again speaking to our stakeholders, we'll be coming out with a view as we talk to all these stakeholders. But in the coming quarter or two, we'll give a precise – more precise range of where we feel comfortable operating.

As we kind of flattened out to that date in April of 2019, do you guys intend to kind of maybe continue to ramp up leverage and maybe ramp up leverage higher than where you historically run at knowing that eventually that – the ceiling is going to get raised in April of 2019?

Yeah, so, look, we've always said historically even before the change in law that given the assets, that PFLT focuses on 0.8 to 0.9 times was not a problem given that that you know the world seems to think these assets can be leveraged safely much more than that. So, certainly, you know higher leverage than where we are now, and as we talk to in our stakeholders every time, we'll actually paint a more, give you more formal guidance, but we've always said 0.8, 0.9, you talked of assets as we've said in the joint venture can get leveraged up to 2 to 1 and middle market CLOs can leverage up to 5 to 1. So, you know we certainly would always want to create cushion from wherever the law is, but we feel really good about this book and the assets that we're generating ability to put more leverage on them.

Okay, and then just one more. I know you mentioned on the last call that you saw more covenants on the debt that you guys having your liability structure, I know you said there is covenant in there with your bonds if you get a two notch downgrade will be about 20 basis point increase, but you've already reaffirmed that. Are there any covenants in the – in your current credit facility today that would prevent you from going above 1 to 1 that would have to be amended?

Yeah. On the credit facility, we're talking to our lenders and we're – we are and we will and you've seen the whole BDC space get redone. Credit facilities were – once process of speaking to our lenders and as we roll out, once we've spoken through our lenders and all the constituencies, we'll roll out a revised guidance, but we really anticipate in the near credit facility.

And we'll take the next question from [indiscernible] with Leader Capital Markets. Please go ahead.

What do you think about the economic environment in general, and are there any specific sector that seems more attractive in the near future?

Thanks Ras and we appreciate you being on we certainly appreciate the shareholder interest that we have in Israel and elsewhere. So thank you for your interest. The economic environment in the U.S. remains strong. We would characterize it as a moderately growing economy. We see EBITDAs of our underlying portfolio growing generally around 5% to 7% a year. We see no signs of a recession at this point. We always underwrite as if there's going to be a recession and when we make investment, we assume there is a recession in the model, and we make sure that we feel very comfortable about credit where recession and we talked about how we did during the last recession. But the economic environment is strong. What that means in terms of industries, are always focused on industries that are more recession-resistant that generate high free cash flow or that free cash flow can be used to pay down debt and to pay off debt. So, and the industry we're focused on right now are business services, distribution and healthcare services, software, industries where we picked up the high free cash flow conversion.

We'll now take a question from Mickey Schleien with Ladenburg. Please go ahead.

Art, because it's been so competitive out there, so me BDCs are certainly having a tough time navigating the sponsored cash flow market, but looking at PFLT the portfolio has about doubled over the last couple of years, and in that time as you mentioned, the yield has gone up sort of in line with LIBOR, which implies you are maintaining your spreads, that you mentioned the recent hires you've made over the last several quarters, I think it would be really helpful for us if you could give some insight as to how the origination team is structured, you know how it attacks the market in order to help you accomplish these trends that we're seeing the last couple of years?

So, it's a good question Mickey and I think that the real answer is our brand and our awareness in the market, right now is greater than our capital. We're kind of moderately sized firm. We're not one of these firms that manages $20 billion or anything. So, when you manage the type of capital that we have and you put our brands to market, which we think is very strong, and then you put very senior, talented investment professional against that in market, in a region, we've been able to generate ample flow for our moderately sized vehicles. So that's what's going on. We hired people into the platform. Again it's a different model. We ask our investment professionals to do deals from end zone to end zone. They are supposed to be helping originate it, diligence, underwrite it, bring it through investment committee, negotiate confidence and then monitor it once it's in portfolio. So we ask them to do end zone to end zone. And importantly and that is, their job is not to originate. They don't get paid a commission to bring a deal in. Their job really is, is to be the line of first defense to protect our capital and to protect shareholders capital and make good investments. So when we hired our Managing Director on the West Coast, we said your title is not Head of West Coast origination, your title is Head of West Coast investment, you are the line of first defense. So that involves him to not only originate, but also he and the team that we assigned to these deals has to own the credit risk and has to make sure they underwrite it properly. I think what's really helped us underwrite, why we've had such a good senior debt track record is because as you know we started out 11 years ago as a mezzanine or subordinated debt shop. And we underwrite senior debt, the same way that we underwrite subordinated debt. And we had a very nice track record underwriting subordinated debt. So, by definition, when we underwrite senior debt, which is usually less risky, we are using the same underwriting discipline. So, why we've had 98% recoveries and all that, I think in part and parcels because of how we underwrite and how we structure.

That's really helpful and insightful. I appreciated it. And if I could just follow up in terms of gauging changes in risk tolerance over those last couple of years. Can you talk about the trends over those last two years in terms of the share of sponsored deals in the portfolio and trends in borrower EBITDA and leverage multiples? What I am getting at is, these have been good solid results, is there embedded in there some additional risk that we should be aware of?

It's a good question. I think the percentage of – as the market has matured and look we've been wrong, we were calling the peak of the credit cycle four years ago, right. So we were perhaps overly cautious, but over those last three four years we've generally moved up capital structure across our platform. The percentage of sponsor deals has grown. We are now doing 90% to 95% sponsor related versus what I say 80% of one point. Why do we like the sponsor related, we like having big equity cushion beneath us. And for us it's been okay. We've said look, we are happy to have a safer book and we are also okay, taking a little bit less risk and a little bit less reward if the book is safer. So, higher percentage of our deals are sponsor, a higher percentage of our deals are senior secured, and yes, leverage levels have crept up. I say for PFLT we are now 4.4 times debt to EBITDA has crept up from about 4 times over the last year or two. So, we are very aware of that. We want to keep it in the lower 4s generally, but we like being at the top of the capital structure. We like having the floating rate. We like having a big, big equity check and in certain cases secondly subordinated check beneath us and what has happened even though our leverage has crept up a little bit, the cushion of capital beneath us whether it be secondly subordinated debt or equity has grown over the last few years.

And has borrower EBITDA remain relatively in terms of the target size of EBITDA of the borrowers that you are looking at, has that changed meaningfully over the last couple of years?

We've always been in the $15 million to $40 million EBITDA zone because once you get above 40 of EBITDA these borrowers can access the broadly syndicated market very efficiently. So, our average if you look at our book, it's probably an average of $30 million of EBITDA, some are closer to the low end of our range and some are obviously at the high end of our range, but it's kind of generally remain stable.

All right. And one last question if I may. When the higher leverage kicks in next year, have you thought about or you contemplating bringing the senior loan fund on to the balance sheet. The reason I ask is that, it would increase in a sense transparency from the perspective of investors. It would also make your non-qualified asset bucket larger, which could give you some opportunities down the road. I understand you want to take care of your partners and perhaps there is a way to do that, but I'd certainly be interested in understanding how you are thinking about that.

So the way the law came down, we already had upsize our credit facility for the PSSL and upsized our commitment and Kemper's commitment right before the law change. The law change has obviously surprised us. We've been – we've got great success with PSSL. We are kind of in the middle of –we invested over $300 million in it, it's a plus $600 million structure. So, we think over the next 9 to 12 months we can get PSSL fully levered. Kemper has been a terrific partner for us. We see – there is a very good type of relationship. We see credit very similarly. So our intention is to grow PSSL and get it fully invested over the next 9 to 12 months. In nine months, it's about April of 2019. So we'll take a look at everything, but we certainly really like our relation with Kemper and we'd like to continue it in a lot of different ways. So, we'll figure it out as we go. In terms of transparency, I mean the SEC requires and its' all, it's in the queue. I think everything is in there. All the investments, just like we would do in a statement of investments in a regular 10-Q. It's all there in our Q. We'd like to go through with [indiscernible] later we're happy to go through it, but name by name, industry cost, fair market value, yields, it's all disclosed in our Qs.

Yeah I know where it's in the Q, I guess and need more transparency, maybe is not the best use of terms. I was just referring to the fact that the PSSL is a separate entity apart from the BDC. But I understand your answer and I appreciate your time this morning. Thank you.

Thanks Mickey.

[Operator Instructions] And we will not take a follow-up question from Ryan Lynch with KBW. Please go ahead.

I just had one follow-up. I noticed this quarter in PSSL, there is about $27 million of investments purchased from PFLT. Can you provide a little background on that? Were those loans that were just recently originated by PFLT, that were just kind of dropped down there over those older loans that have been on PFLT's book for several quarters that were sold down into PSSL. Can you just give a little background? And I guess thought process of how you guys are thinking about what moving investments into PSSL. Why that occurs?

Yeah. It's a great question. I mean some deals go right into PSSL, some deals need to be seasoned by PSLT due to rules and regulations around self-originated deals. So, in certain cases, PFLT has to buy it and hold it for a while and season it, and then it can go on to PSSL. Some are just deals we've had grown and PSSL, i.e. Kemper really liked them and want them to go into PSSL. So it's a combination of three ways the deals find there and there is three ways to just find a way to PSSL. One is upfront, two is it needs to be seasoned for a while in PFLT, and three is we're just growing the position in PFLT and PSSL wants it. And it's very efficient for us to move it over to PSSL and that's all done at fair market value, whatever the valuation firms come up with the value, it's all based on that.

So it's fair to assume then going forward we can expect most likely sub level of sales from PFLT's balance sheet and PSSL going forward?

That's right. Look we really like PSSL. As I said, we really like the relation with Kemper and we like the efficiency of capital. And we think we got another 9 to 12 months to get a fully deployed and that will be very creative to shareholders. And we'll pick our head up and we'll see where we go, but it's – we're very pleased with financing with Capital One, so when they broke, they'll fix it.

And that concludes our question-and-answer session. I'd like to turn it back to Art Penn for any additional or closing remarks.

Just want to thank everybody for being on the call today. Thank you for your interest. We'll be talking to you in mid-November, which is when our next quarterly call happens. So reminder, it is our 10-K, so call happens and our K filing happens a little bit later than our normal Q filing would happen in November. So look forward to speaking everybody and we'll talk to you soon. Thank you very much.

Thank you very much. That does conclude our conference for today. I'd like to thank everyone for your participation. And you may now disconnect.