PennantPark Floating Rate Capital Ltd. (PFLT) Q2 2019 Earnings Report, Transcript and Summary

Good morning and welcome to the PennantPark Floating Rate Capital Second Fiscal Quarter 2019 Earnings Conference Call. Today's conference is being recorded. At this time, all participants are 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'd like to welcome you to PennantPark Floating Rate Capital's second fiscal quarter 2019 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'd like to remind everyone that today's call is being recorded. Please note, that this call is the 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'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 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 December 31, we invested $136 million primarily in first lien senior secured assets at an average yield of 8.7%. PennantPark Senior Secured Loan Fund or PSSL continued to perform well. As of March 31, PSSL owned a $503 million diversified pool of 43 names, with an average yield of 8%. Over the last several years, we have substantially grown our platform by adding senior and mid-level investment professionals in regional offices as well as New York. The additional people in offices combined with additional equity and debt capital we have raised, has significantly enhanced our deal flow. This puts us in a position to be both active and selective. Net investment income was $0.30 per share. Due to our activity level and the maturation of PSSL, we are pleased that our current run rate net investment income covers our dividend. Our earnings stream should have a nice tailwind based on gradually increasing our debt to equity ratio, while still maintaining a prudent debt profile. As of September 30, our spillover was $0.31 per share. With regard to the Small Business Credit Availability Act, a reminder that our board approved and modified the asset coverage that was included in the law, reducing asset coverage from 200% to 150% effective April 5, 2019. Overtime, we are targeting a debt to equity ratio 1.4 to 1.7 times. We will not reach the target overnight. We will continue to carefully invest and it may take us several quarters to reach the new targets. Given the seniority of our assets, we're actively considering utilizing CLO financing to help achieve the target. The Company has generated an excellent track record over the last eight 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 to provide attractive returns for our investors. Our successful operation of PSSL, which is today operating at that same targeted debt equity ratio, is evidence of this strategy. 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 managed from our offices in New York, Los Angeles, Chicago, Houston or London. We have done business with about 180 sponsors today. 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, managing teams and intermediaries, the one consistent credible capital. As an independent provider free of conflicts or affiliations, we've become a trusted financial partner for our clients. As a result of our focus on high quality companies' seniority and capital structure, floating rate assets and continuing diversification, our portfolio was constructed to withstand market and economic volatility. The cash users coverage ratio, the amount by which our EBITDA or cash flow exceeds cash interest expense continued to be healthy a 2.8 times. This provide significant cushion to support stable investment income. Additionally, at cost, the ratio of debt EBITDA on the overall portfolio was 4.3 times, another indication of prudent risk. In our core market of companies with 15 million to 50 million of EBITDA, our capital is generally important to the borrowers and sponsors and we are still seeing attractive risk reward, receiving covenants which help protect our capital. It's been two years since we have a non-accrual of PFLT and that run had to end at some point. As of March 31, 2019, we had four non-accruals. These names represented by 3.2% of our overall portfolio at cost and 1.5% on the market value basis. The four non-accruals along with a mark-up of our credit facility and bonds contributed to most of the NAV decline in the quarter. Our credit quality since inception eight years ago has been excellent. Out of 349 companies in which we have invested since inception, we've experienced only nine non-accruals. Since inception, PFLT has made 349 investments totaling about $3 billion and an average yield of 8%. This compares to an annualized loss ratio, including both realized and unrealized losses of only about six basis points annually. With regard to the economy and credit cycle, at this point, our underlying portfolio indicates a strong U.S. economy and no sign of recession. From an experience standpoint, we're one of the few middle market direct lenders who was in business prior to the global financial crisis and have a strong underwriting track record during that time. Although PFLT was not in existence back then, PennantPark as an organization was, and at that time was focused primarily on investing in subordinated and mezzanine debt. Prior to the onset of the 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 down 42%. As a result, the IRR of 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 the highlights. We purchased $7.5 million of the first lien term loan of By Light Professional IT Services. The Company's a provider of IT services to the government, Sagewind Capital is a sponsor. We funded $300,000 of revolver and $26.7 million of first lien term loan of Perforce software. The Company is a provider of version control project management and code testing software. Clearlake Capital is the sponsor. We funded 1.7 million of revolver and $13.3 million of first lien term loan of Solutionreach. The Company is a provider of Software-as-a-Service patient relationship management tools for the health care market. Summit Partners is the sponsor. We purchased $20 million of the first lien term loan and funded $200,000 of the revolver of TVC Enterprises. We also purchase $500,000 of the common equity. The Company provides membership based legal services commercial truck drivers. Gauge Capital is the sponsor. Turning to the outlook, we believe that the rest of 2019 will be active due to both growth and M&A driven financing. Due to our strong sourcing network and client relationships, we're seeing active deal flow. Let me now turn the call over to Aviv, our CFO to take us through the financial results.

Thank you, Art. For the quarter ended March 31, 2019, net investment income was $0.30 per share. Looking at some of the expense categories, management fees totaled about $4.9 million. General and administrative expenses totaled about $1 million. And interest expense totaled about $5.3 million. During the quarter ended March 31st, net unrealized depreciation investment was about $12.7 million or $0.33 per share. Net realized gain was about $1.1 million or $0.03 per share. Net unrealized appreciation on our credit facility and notes was $5.6 million or $0.14 per share. Net investment income exceeded the dividends by $0.02 per share. Consequently, NAV went from $13.66 per share to $13.24 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 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 remains highly diversified with 88 companies across 29 different industries. 88% is invested in first lien senior secured debt including 13% in PSSL, 3% in second lien debt and 9% in equity including 5% in PSSL. Our overall debt portfolio has a weighted average yield of 9.1%. 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 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 would like to open up the call to questions.

Thank you. [Operator Instructions] And our first question comes from Mark Hughes with SunTrust.

This is Michael Ramirez in for Mark Hughes. Thanks for taking our questions this morning. Regarding your other income line, it seemed, I guess it was elevated again this quarter similar to the September period. Cloud you please give us some sense about how much of the repayment fees account for this line item over in this quarter and over the last few years?

Sure. There was some structuring fee we received this quarter, which were most of it. We did have a small residual proceed from the MCG litigation that were involved and that was part of it as well. So, that was a piece of it, but it was mostly repayment fees and structuring fees.

And just additionally, I guess, a quick follow-up on that. Given that the prospects for short-term interest rates are not going to rise as quickly as in prior years. Could you please give us a sense of, I guess, I know this is hard to quantify, but repayment activity over the next year?

Yes. So, look, repayment in this environment is due mostly two companies performing getting sold or refinancing. Most of the portfolio is performing well. We typically see a quarter to a third of the book, turnover each year, and I think this year would be we estimate the same amount.

And then I guess on the non-accrual, it seems that you've been marketing for companies down for the last few quarters or so. So I guess our question is. Have you changed your criteria or potentially lower the bar for what constitutes a non-accrual investment on your books?

No. Non-accrual is very simple, which is they stopped paying us interest. So, that's what happened. Look, we haven't had a non-accrual and over two years, it looks lumpy here and we're certainly disappointed, but non-accruals are part of this business. It's unfortunate that they all happened in this one quarter. But we normally, they'd be smoothed out overtime and we had, as you said, we already had already marked the down by and large. So, this should not have been a big surprise to people to know for them were exhibiting weakness in the past. So, as part of our business, again our track record over a long period of time PFLT now eight years is really only annualized loss of 6 basis points. And when you're talking about an averaging 80% type deal, that's very low, it's unfortunate all these happened in the same quarter but that's just kind of business we're in.

And I guess, maybe one last housekeeping one from us. I believe spillover is $0.31 last quarter, do you have an update for this quarter?

Yes, so, we disclosed once a year and at September, so it was -- that $0.30-$0.31 that we talked about. It’s not much different today than what it was in September. It’s right around that.

[Operator Instructions] Our next question comes from Ryan Lynch with Keefe, Bruyette & Woods.

First question or I guess part of the comment. Overall, I would agree you guys long-term track record is still very good. It’s just the timing of these four was definitely unexpected of these four new non-accruals. As far as your guys marked on them, LifeCare Holdings and New Trident, the new health care investments are marked down significantly more than the other two Holland and Quick Way. Can you just give a comment on I guess what you guys are seeing with maybe particularly Hollander Sleep Products worth on non-accrual but you still have a pretty high fair value mark?

Yes, look, we more importantly the independent valuation firms and auditors look at every deal every quarter. The independent valuation firms come up with these marks. They’re based on a number of different factors including largely when a company goes on non-accrual kind of enterprise value waterfall approach, taking a look to comparables, taking a look at the Company where those comparables are trading, what a waterfall will look like, evaluation of the Company will look like in a restructuring scenario. So, that’s where, where these numbers came up with. The two healthcare deals Trident and LifeCare have been marked down for awhile. They're both relatively small. They were on the wrong side of changes in healthcare. Those should not have been surprises and you said it was unexpected. I guess if you had no non-accruals for two years, it is unexpected to have four on one quarter. But hopefully, people understand non-accruals are part of this business. We get them from time to time and we had marked to these. The vast majority of deals already down. So, hopefully, it wasn’t a total shock to people. But I don’t know I answered your question, Ryan. Any other elements to that question that you wanted to get some more detail about?

Well, maybe just slightly different question on that. I mean with the two healthcare deals you mentioned maybe on the wrong side, maybe some ruling or regulation with those. Does that change your outlook or strategy for investing into healthcare industry? What did you basically learn from these two investments? And does that change your outlook for that industry?

Yes, look, we try to learn lessons from every mistake we make, and I think certainly the filter around healthcare will be even higher going forward and knowing that shifts in healthcare can move quickly. And importantly, what we’ve tried to do -- and buy and large, healthcare performance has been very good, what we’ve tried to do is when we’ve invested in healthcare companies invest in companies that are driving the change, that are helping, helping bring higher quality at a lower cost to patients. So buy and large, the healthcare track records, it's has been very good overtime. These two relatively small investments got caught on the wrong side of it and we got caught on the wrong side of it. So, we will continue to -- try to learn lessons from our mistakes, increase the filter and try to reduce mistakes in healthcare and elsewhere going forward.

And then one more company specific questions. As far as Country Fresh goes that was a -- it's a fairly sizable investment that had a pretty big markdown this quarter. It's still on accrual status. Obviously, it's still paying you guys interest income, but any sort of outlook on that investment given that is now at 66% of your cost?

Yes, you're going to see a restructuring of that investment in this quarter end of June.

And then one final one, you guys have done a really good job of growing PSSL. I think you guys are getting pretty close to that investment being fully funded with the original commitments you guys set up. What is the outlook are you guys planning on, on growing that your original sort of commitment size and then having that run as is? Or is there any thought to potentially expand that further? Or do any other sort of JVs?

Look, it's worked well. I think the relationship and partnership with Kemper is excellent. It's again of matured but we like it. So, we have no current thoughts of collapsing in onto our balance sheet. We like, I think our intention is to keep running it. It's getting up there in terms of getting fairly optimized. So, I think it's probably steady as she goes, maybe it could be optimized a little bit more, but we kind of like the way it is. It's generating a very healthy income for our shareholders. And I think we're just going to kind of keep running it as is, where you might see changes are and I alluded to it in the script is the CLO securitization style financing that we're looking at within PFLT itself. So, it's something that may happen here in the coming months where we do kind of CLO within PFLT, which is a very cost effective financing and also will help us get to our target leverage, which should increase our NII and ROE.

And the next question comes from Ray Cheesman from Anfield Capital.

Good morning, Art. Thanks very much for taking the question. And thanks very much for answering Ryan's question about always learning from mistakes. It's always a good thing to hear. I would like your opinion on rates and spreads. Obviously, the markets have been jumping 60% rate cut, 40% rate cut, 60% rate rise, 40% rate rise. What do you guys see down in the level that you play in from a spread and rate trend basis, as you look out across the next couple of quarters? Again, we all can see the Bloomberg big articles about the economy and rates in people's opinions. But what's happening down in the trenches where you guys are actually cutting deals. Like you mentioned, you're getting indenture provisions. You got to go pretty far down to get something nowadays otherwise you just take plain vanilla and that doesn't come with much protection. So, I'm interested in your views.

Yes. So, we're focused on companies with -- and it's good question. We're focusing companies with 10 to 15 EBITDA, the median or mean is probably about 25 million of EBITDA. And clearly, the closer you get up to 40 or 50, the more you're competing with a broadly syndicated again what you called up in a plain vanilla space broadly syndicated covenant light. So, we're typically getting covenants. We're typically important to the borrower. We can typically drive upfront fees. And we think the package of senior debt that we can originate and structures pretty attractive. The economy overall is pretty good where we've seen bumps and we saw some this quarter either a little change in health care here or there, or some of these pro forma supplemental adjustments, don't come in. People are doing acquisitions and they stub their toe doing acquisition. So, it comes out of a relatively healthy economy, but there are mistakes. Now, we are seeing labor costs arise. So companies that do have a more labor as component of their costs are having challenges, keeping labor, paying labor, and that's where we've seen a little bit of tension. But it's hard to really complain about high labor costs because that really comes from a strong economy and the strong economy is very good for these portfolios. In terms of the rates, look, the economy remained strong and that would kind of lead you to believe that the Fed may not want to reduce rates. But as you know, I'm reading, you, what's on Bloomberg. Sometimes, what's going on the real economy doesn't have that much of effect on Fed policy. But what we're saying is, the economy is relatively strong. And with labor costs rising, there might be a little bit of inflation. And when so many things are going, they aren't going to be any great changes in the intermediate term.

We'll take the next question from Doug Crimmins with RVP.

I was looking for you to comment on the long-term non-accrual. Obviously, the market has been quite surprised given the reaction. And I understand what you think are the prospects for these loans recoveries, et cetera, going forward.

Look, we -- the loans have been marked fairly by independent third-party evaluations terms. We agree with the marks. I mean, I think, inherent in the marks gives you a sense of what we think a least value is today. I will mention Doug that we do have a really good long-term track record, working things out and getting really good recoveries overtime. We've, had a lot of experience, when we have to convert that equity and we have -- it's been, we've been in business until the years including doing even second lien subordinated debt. We've had a very good track record working things out, getting value back for our shareholders. In some cases, the equity security that we end up owning performed very, very well. So, we of course beliefs marks -- the current marks are accurate, but current may or may not reflect future value. So, I do want to mention we also have a very healthy equity co-invest piece of this portfolio, which is performing well and we expect in the names like By Light, DecoPac, GCOM, IIN, which are already marked up to continue to perform well to tell fill some of the gaps we have on some of our non-accruals. That's one of the reasons we have a little bit of an equity co-invest portfolio is to have some securities in the portfolio that has some upside that can fill some gaps. And I think if you look, look at the portfolio, see some nice embedded gains that you continue to grow overtime. It is unfortunate we have four non-accruals this one quarter after having two years without non-accrual. To us, there’s no big macro change to what’s going on. We expect non-accruals in our business. That’s unfortunate. It had all the four mapped into one quarter. But we still think we’re generating very attractive risk adjusted return including the debt, including the equity co-invest and even including when we have to convert debt to equity and getting shareholders back to capital.

Right, but I mean like LifeCare marked at 20 and New Trident marked at 4. I mean, it doesn’t sound like the prospects were particularly optimistic.

That’s correct. We think that those are marked. We think they all marked accurately. We’ll see where all comes out in the wash when we exit, but we think the prospects hence the market of those companies is reflected in the mark.

Okay, thank you.

Conversely, if you look at some of the equity investments we have, By Light, DecoPac, GCOM et cetera. We think there’s very good prospects for those companies. So, that’s why you have a diversified portfolio and you have some -- you're going to have some losses, you’re going to have some gains and long run it all comes. It all comes down the wash, 6 basis points -- 6 basis points annualized loss over eight years compares very favorably to anyone in the market place.

And Mr. Crimmins, do you have any further questions?

No, that’s it thank you.

Thank you. And that does conclude the question-and-answer session. I’ll now turn the conference back over to Mr. Penn for any additional or closing remarks.

I want to thank everybody for their participation today and we look forward to speaking to you in early August at our next quarterly conference call. Thank you very much.