PennantPark Floating Rate Capital Ltd. (PFLT) Q1 2020 Earnings Report, Transcript and Summary

Good morning, and welcome to PennantPark Floating Rate Capital's First Fiscal Quarter 2020 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'd like to welcome you to PennantPark Floating Rate Capital's First Fiscal Quarter 2020 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 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'd also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at pennantpark.com or call us at 212-905-1000.At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Thanks, 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-up for Q&A. We were active in the quarter ended December 31. We invested $239 million in primarily first lien senior secured assets with an average yield of 8.2%.Pennantpark's Senior Secured Loan Fund or PSSL continued to perform well. As of December 31, PSSL owned a $493 million diversified pool of 49 names with an average yield of 7.4%. And we have only one non-accrual, which represents only 0.4% of the cost and 0% of the market value of the portfolio.Over the past 12 months about 75% of our investments were in existing borrowers. These were generally cases, where we had an option to continue to finance an existing borrower or could opt out. To us, this incumbency is the best of both worlds. Staying with solid credits with reduced competition, or choosing to exit, in a market where investors are asking about differentiation among middle-market direct lenders, the value of incumbency can be overstated.With 135 borrowers in our overall platform, we are deriving substantial benefits of incumbency. Our growing team, capital resources and incumbency put it in a position to be both active and selective. Today, we are only investing in approximately 4% of the opportunities that we are shown.Net investment income was $0.29 per share. Due to our activity level and the maturation of PSSL, we are pleased that our current run rate and investment income covers our dividend. Our earnings stream should have a nice tailwind based on a gradual increase in our debt-to-equity ratio, while still maintaining a prudent debt profile.As of last fiscal year, our spillover was $0.31 per share. As of December 31, our debt-to-equity ratio was 1.4 times. We are targeting a debt-to-equity ratio of 1.4 to 1.7 times. We will carefully continue to invest and optimize our leverage over time. A careful and prudent increase in leverage against a primarily first lien portfolio should lead to higher earnings.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 and Houston. We've done business with about 190 sponsor's 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 in our investments.We remain primarily focused on long-term value and making investments that will perform well over several years and can withstand changing business cycles. Our focus continues to be on companies and structures that are more defensive, have reasonable leverage, covenant protections and attractive returns.We continue to be 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 are a trusted financing partner for our clients.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 healthy 2.4 times. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt to EBITDA on the overall portfolio was 4.2 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, we are still seeing attractive risk reward, we are receiving covenants, which help protect our capital.Our credit quality since inception nearly nine years ago has been excellent. Out of 373 companies in which we have invested since inception, we've experienced only nine non-accruals.Since inception, PFLT has invested over $3.5 billion at an average yield of 8.1%. This compares to an annualized loss ratio, including both realized and unrealized losses of approximately nine basis points annually. With regard to the economy and the credit cycle, at this point, our underlying portfolio indicates a strong U.S. economy and no signs of a recession.From an experience standpoint, we are 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 of 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 made 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 $5 million DRS Holdings Dr. Scholls first-lien term loan and committed about $1 million of revolver. Dr. Scholls shows is a leading brand in the foot care category in North America including insoles, skin treatments, and orthotics. Yellow Wood is the sponsor.ECM is a provider of a broad range of tools and consumables for electrical and harsh environmental applications under highly regarded brands. We purchased $5.1 million of ECM industries first lien term loan as well as about $1 million of revolver and common equity. Sentinel Partners is the sponsor.We purchased $21.7 million of the first lien term loan of Smartronix, Trident Technologies. The government is a government contractor -- the company's government contractor providing IT modernization, cloud services, defense systems, engineering, and intelligence surveillance and reconnaissance solutions. OceanSound Partners is the sponsor.Sales benchmark Index is a management consulting firm that exclusively focuses on helping its clients drive sales. We purchased $14 million of the first lien term loan, delayed draw term loan revolver and equity of the company. CIP Capital is the sponsor.STV Group Incorporated provides specialized consulting services and engineering and architectural design as well as project management, primarily for transportation infrastructure. We purchased $19.8 million of the first lien term loan. The Pritzker Organization is the sponsor.Turning to the outlook, we believe the rest of 2019 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 December 31st, 2019, net investment income was $0.29 per share. Looking at some of the expense categories. Management fees totaled about $5.1 million, general and administrative expenses totaled about $1 million, and interest expense totaled about $7.3 million.During the quarter ended December 31st, net unrealized depreciation on investment was about $3.5 million or $0.09 per share. Net realized gains was about $1 million or $0.03 per share. Net unrealized appreciation on our credit facility and notes was $0.04 per share. Net investment income equaled the dividends.Consequently, NAV went from $12.97 to $12.95 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 independent valuation firms, 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 remains highly diversified with 102 companies across 43 different industries. 89% is invested in first-lien senior secured debt, including 10% in PSSL; 30% in second lien debt and 8% in equity including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 8.4%. 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 to that goal. We try to find less risky middle market companies, a high free cash flow conversion. We capture that free cash flow primarily in first-lien senior secured 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 we will take our first question from Mickey Schleien with Ladenburg.

Good morning everyone. Your platform has extensive experience in oil and gas investments. And I'm interested to understand how you may be leveraging that into alternative energy? Are there borrowers in that space, which meet your investment criteria? And how do you see the opportunity in that segment developing?

Yes. It's a good question Mickey. It's -- the alternative side is something we haven't done much in if anything. We are focused particularly today on kind of sponsor driven businesses where there's a lot of equity underneath us. Our loan-to-value is wrong. We have very good coverage and where there's cash flow to pay us down. So we haven't really seen much in the alternative energy space coming out of the middle market sponsor arena.

Okay. Thank you for that. That's all my questions for today.

Thank you.

And we'll take our next question from Michael Ramirez with SunTrust.

Hey, good morning guys. Thank you for taking my questions. I guess regarding your investment activity just looking at the exits and repayments, it seems like they've averaged roughly say 13% of the total portfolio on a quarterly basis over the last year. So while we understand repayments are difficult to predict, do you think this trend should continue through the calendar year of 2020, or are you seeing like other indications that the portfolio could possibly see a path to a slower turnover within next year?

It's a great question. And obviously, it's hard to predict Michael. We think there's going to be a lot of deal activity between now and the election. We think people are going to want to do deals pre-election. So we think we are going to be active. That could also mean there's repayments coming out of that. And this is why we kind of talked about incumbency is in certain cases there's going to be companies sold out of our portfolio where we'll have an option to stay in or an option to exit and that's the best position to be in because these will obviously be credits where we have almost perfect due diligence on. So hard to predict the amount of repayments, but we do think we will be active both on the buy side and perhaps on the sell-side as deals get to between now and November.

Okay. Great. And I appreciate that. Just another one on the investment portfolio. We just heard of you talk about how you have investments in 43 industries are very – recall correctly last quarter was 37. Is this just new classifications, or are you guys entering new industries?

Yes. These classifications are from one of the rating agencies. I think I'd say the Moody's or S&P. And when the deal comes in we try as best we can to map to whatever bucket there is within those categories. We had a very, very active December quarter.As you saw, $239 million deployed, which was high, we think a lot of people wanted to get deals done before year-end. We think people want to get deals done before the election and we were pleased with the flow. We were pleased. Importantly, that we can maintain very high credit standards.We talked about how the deals we're doing is kind of debt-to-EBITDA in the mid-4s to low 4s still getting over an 8% yield on average has very attractive risk-adjusted return for us. These deals are primarily, if not all first lien top of the capital structure, no more than 50% loan-to-value.So sponsors are putting a lot of equity in these deals. And we're in a position where we can be very, very selective about what comes into the portfolio and still be active. And that's where the team we've built over the last number of years around the country, the incumbency from 135 for names we have in the portfolio gives us a really good opportunity to review what's in the market and only pick those credits where we feel very safe where we're getting covenants and where we feel protected in this environment.

Okay. Great. Thank you for that answer. And if I may on the balance sheet. It looks like the payables for investments purchased line increased over about $70 million from the prior quarter. I guess is the – does this mean some of the new investments are back-end loaded in the quarter? And if yes, say for example, if we took this new investment, it was like more towards the beginning of the quarter, how much would that have contributed to investment income?

It's a good question. I think the investments already is trades that were done just prior to year-end that we were going to close in the first week or two of the year. So that's a big chunk of it. Look, you can do the model. We're a 1.4 times leverage as of quarter end. We say we have a target up to 1.7.We're going to work to optimize within that. And we're also going to work to optimize our joint venture with Kemper PSSL, which is not fully optimized yet. And I think if we optimize both the PFLT balance sheet as well as the PSSL balance sheet over the coming quarters, we're going to pick up $0.02, $0.03 per share per quarter.

Okay. Great. And one last one if I may more on a macro I guess. On the regulatory front, could you please give us your thoughts on the coalition for business development, we're drawing its AFFE rules application to the SEC. And actually, additionally do you believe there's another path to relief from AFFE?

It's a good question. We're not on the forefront of that. We are involved in the SBIA. From what we hear from the experts who are involved, they're still optimistic that that something can happen kind of either through discussions with the SEC or through legislative areas. We're not that close to kind of those discussions we're involved and obviously, supportive and allocating time and resources to it but we're not – there's others who are better positioned to answer that question.

Okay. Thank you, Art. That’s all for me. Thanks.

Thanks.

And we'll take our next question from Paul Johnson with KBW.

Good morning, guys. Thanks for taking my question. The first question was around just sort of your optimal leverage range. Earnings today cover the dividend pretty well. Obviously, the yield outlook has decreased quite a bit with LIBOR moving lower. I'm just wondering is there a point or any point where you probably start to hold back on growth perhaps tap the brakes a little bit on originations just given the lower yield outlook and probably the limited increase in earnings that you would get from higher leverage?

Yeah. It's a good question. Some we think about a lot, Paul, and it's always a debate. Look I think, in general, the kind of risk-adjusted returns we're getting today where we're getting low to mid-4s debt-to-EBITDA and we're averaging 8% on that.In general, we think that's going to weather any kind of storm and still generate a safe return for our shareholders. We did a CLO within PFLT last quarter. And as you know CLOs take the same exact collateral and can leverage it three or four to one and still be safe and feel safe that they're leveraging the same collateral three or four to one.We're not suggesting that here. But we are suggesting that as long as we can underwrite really solid deals, we can operate with our target. The target is still less than the regulatory constraint of two to one. Our target is 1.4 to 1.7. So even if we go to the high end of our target, we still have cushion relative to the regulatory constraints.And then we have this PSSL joint venture with Kemper, which has had very nice returns and is now $500 million and is not really quite optimized. So, we could -- and we are thinking about how we get higher returns from that entity and get a little higher ROE, which obviously since PFLT owns 87.5% of it enhances the earnings at PFLT.So we're optimistic that number one the deals that we're doing today will stand the test of time and will play well in any environment given the leverage, the covenants where we are in the capital stack. That can be leveraged reasonably within certainly our target and the regulatory constraints. And we think we can over time get to north of $0.30 maybe as high as $0.31 or $0.32 and as we optimize these tools.

Okay. Great. Thanks for that. And my second question is had to do with LIBOR and loan spreads in the market today. Obviously, there's been a pretty meaningful move lower in LIBOR. But last year while LIBOR was moving higher, we saw spreads kind of tighten along the way. I'm wondering, are you seeing any of the decline in LIBOR today being offset by perhaps higher spreads in the middle market?

What we can say -- I could say, for sure that spreads have not been coming down and we have seen select cases in new financing where spreads are widening a touch. And I would not call it a major trend at this point. I would not pound the table and say, it's happening. But I would say there's perhaps some green shoots in that regard recently where the spreads have widened a little bit. So, hard to say. We'll see what happens. But for sure we're not seeing tightening at this point.

Okay. And my last question just it has to do with deal flow. You talked about having a pretty active fourth quarter closing decent number of deals. Do you believe -- I'm sorry, I'm talking about calendar fourth quarter obviously. But do you believe that because of that active quarter that you -- that pull forward of deals essentially would that potentially affect any of the first quarter of 2020 originations?

Good question. Usually you could say, there's a seasonality to our business where people want to get deals closed by December 31 of calendar fourth quarter. And then usually there's a low in the first calendar quarter of the year.Here we are months in five days, six days into it. Hard for me to pound the table either way on that. As I said, I think the overall umbrella is that people want to get deals done before November, which is the election. So we believe we will have an active nine months, 10 months going into the election. I can't with the precision tell you what's going to close on either side of March 31 at this point Paul. We're busy. We're looking at a lot of stuff. It's a lot of deals in the market. It's hard to tell you with certainty what this first calendar quarter is going to look like unfortunately.

Okay. Thanks for that. That's all my questions.

Thank you.

And our next question comes from Chris York with JMP Securities.

Good morning guys and thanks for taking the question. First is on PSSL, so the net investment income declined sequentially and is now below the distribution -- the dividend distribution to PennantPark for the first time in I think about two years. So is this quarterly level of roughly $1.6 million sustainable to Pennantpark?

It's a great question. What happened was intra-quarter PSSL shrunk and by quarter end PSSL is now above where it was the prior quarter. And sitting down with Kemper and talking about the game plan for PSSL. We intend to grow PSSL. So that's all you saw was a temporary shrinkage of PSSL and we believe PSSL is going to grow. That's our game plan. And, thereby, not only covering the dividend to PFLT hopefully generating some upside above and beyond that.

Got it. And then second question is the weighted average leverage that you provided here on the call this morning for your portfolio companies declined from 4.6% to 4.2%, or is that a function of amortization EBITDA growth or maybe even investment activity in the quarter?

Yes, it's a great question. It's a little of all of the above. We've had good performance. Our portfolio is clean; it's been clean for a while. It's been clean for as far as I can say and I'll down the table little bit nine years. We had a spasm about a year ago where we had a few nonaccruals. But prior to that, we had no nonaccruals for two years. It’s been about a year since we've had some nonaccrual. So portfolio is solid deleveraging nicely. The new deals are coming in. We're keeping our standards high and kind of staying in the mid-fours in terms of new yields. And we're pleased with the -- what's going on.I mean in an environment where people are wondering where the best risk-adjusted return is and what should they be doing? And are we at the beginning or end of the cycle of what's going on and this that and the other. I mean, senior secured loans with 50% loan-to-value mid-fours debt-to-EBITDA at 8% it's a really good place to be we think. It's a really good place we think defensive solid yield. It's well protected with equity cushion. So we're beating the drum on the asset class and certainly on the kinds of deals we're doing.

I beat that drum on the asset class as well. So I share that sentiment. Secondly, on maybe just talking about the portfolio. So I noticed you wrote down the recently restructured equity in both Country Fresh and Quick Weight Loss. So could you update us on the performance of both of those portfolio companies? And then your confidence in the debt for them being paid back?

Good question. Clearly both of those companies by definition of the write-down have been underperforming. So we're working on both of them. I think Country Fresh has some nice ups. They're just getting their act together post their restructuring.Quick Weight Loss, we'll see. Quick Weight Last Juries out. It's a relatively small piece of the portfolio. I will also comment that we have a number, quite a few equity co-invest in the portfolio. And by design we have those equity co-invests and you can see a bunch of them are marked up Chris to help offset declines that we have from time-to-time and problems we have.So you've pointed out two areas of historical weakness of both country fresh and quick weight loss. You can look at our equity co-investment portfolio and there's a lot of different names that are performing very well. And have been valued at higher levels and that's what we're supposed to be doing from a portfolio management standpoint is having some of that to help offset their losses.

Got it. And just to reiterate it seems you feel more confident about Country Fresh than Quick Weight Loss. Is that fair?

Well, we're right in the middle of weight loss season here in February. So post-Christmas is weight loss season. So I'll have a lot more color for you next quarter on that one.

Fair enough. And then in light of changes in the direct lending market over the last couple of years, what do you think you guys have the greatest competitive advantage today that results in the sponsor making PennantPark, the platform being the first call today to be a partner?

Well, it's a great question. We've been doing this a long time as we continually reiterate. We are well-known -- we are well liked. Our financial sponsor clients give us a first call and we like to think we get a last look because of that. So that allows us to participate and win deals or get big chunks of deals, if we want to, but also allows us to pull back when we don't really want to play.So that what we'll call -- we call it incumbency where we have 135 existing borrowers, but it's also been 13 years at PennantPark and decades before that. One thing, I will point out which I think plays to our strength today is with the rise of very, very large direct lending peers you see more and more of those direct lending peers do -- doing very, very large direct loans that would have gone to the broadly syndicated market.And I saw one a couple of weeks to $1.4 billion “extra loan”. from one of our peers or as a group of our peers some of the mega funds and god bless. But the last thing we would want to be doing is competing with a broadly syndicated loan market, where leverage is high there are no covenants. And kind of -- you're kind of pricing for the last basis point.So we're very pleased that some of those folks are vacating, what I'll call the traditional middle market which is where we play in $15 million to $50 million, $15 million to $40 million. If you want to own in on it's $15 million to $30 million EBITDA companies that are just too small for these guys to focus on anymore.And where we can be important to the borrower drive covenant protections drive yields, drive upfront fees and deliver a very nice package. What you're seeing in our results where we can deliver debt-to-EBITDA in the mid-4s with covenants at an 8% yield.So to me that's very positive for where we are positioned. And the last thing, I would want to be doing is competing with the broadly syndicated loan market.

That's great color. In light of some of those comments especially on size, what do you think is the largest deal size you would want to hold at Pennantpark floating today? And then maybe originate at the platform? And then one of the reasons, why I asked because I've noticed some maybe you follow-on investment activity at PFLOAT where it seems your largest size is maybe $35 million. So any update there could be helpful?

Yes. It's a great question and it's something we obviously think about because diversification is a key attribute. We're searching for PFLT has many, many, many names is probably too diversified. But it's -- we want to be very, very diversified. So -- and we have a bunch of vehicles that are growing outside the BDC and we have a bunch of limited partner relationships who want to see flow from the platform.So I think today we have a name that's $120 million between our vehicles and our close limited partners. I mean that's kind of where we are today, but that ebbs and flows depending on the capital, we have at the various vehicles and the LP relationships, but it's significant. And for companies in that $15 million to $30 million zone that can solve a lot of problems.

Sure it can. Last one is any changes at the platform or addition to the platform that are relevant. You mentioned some other funds that could be beneficial to party?

Yes. So I think we made a press release maybe 6 months ago about closing on additional capital and we've got other funds in the market. I want to be careful. I don't want to use a conference call to market private funds. So just to be clear, I'm not marketing private funds here.But we have other vehicles in the market and other relationships that we're developing into managed accounts. And there's a variety of different things going on. And then this whole theme that we've been talking about where you can derive very good risk-adjusted returns and senior debt that plays in the market.And we also have a very strong track record and opportunistic which is slightly higher-yielding stuff. You see that playing out in PNNT and higher yield first lien, occasional second lien, occasional as equity co-investment occasionals and secondary opportunities. That can be very attractive for people as well.

Great. You've been generous of your time. Thank you very much, Art.

And we'll take our next question from the Ray Cheesman with Anfield Capital.

Art, this is really more of a high level macro question. Over the last year, you've done what you said you were going to do. You deliver us low leverage, solid credit, good dividend, well covered. And yet the market trades you at slightly under 94% of your NAV.While in the background we see FS and KKR get together and their stock rise. ARCC and American Capital get together, their stock rise. Golub swallow its sister fund and their stock rise. Where is the place that you'd like to put PFLT, so that it would get credit from investors for strengths without, and I totally understand, competing with that crazy place where the people don't get any coverage of their money and savage each other for increasingly less spread? How do you see that in the future?

Look, we can control -- two questions, Ray. We think about a lot. We can control, we can control, we can choose our investments, which we hope to choose wisely, we can manage our capital structure. And the different facilities and leverage and joint ventures, we do not control the stock price. That's clear.We've been buying the stock personally as management, but we cannot control the stock price. We are not pleased with where our stock is trading, clearly, relative to the performance. When you think about the nine years we've been in business. And the rock-solid performance we've had over that period of time.So, look, we're all ears, Ray, and others, if people have suggestions about how we can better articulate the story to the marketplace, meet investors, kind of, position things, we are all ears. Ultimately, we want to deliver a safe and steady cash flow stream to our shareholders. We think we're doing that. There's no change in that strategy. And we're hoping that at some point, the market recognizes its value proposition.

Thanks for delivering guidance to us who have faith.

Thanks Ray.

And there are currently no other questions in the queue at this time.

Great. I want to thank everybody for participating today. We really appreciate your interest in the company. And we will talk to you next quarter, that will be in early May, that will be our next quarterly conference call. Thank you very much. Bye-bye.

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