PennantPark Floating Rate Capital Ltd. (PFLT) Q2 2021 Earnings Report, Transcript and Summary

Good morning, and welcome to the PennantPark Floating Rate Capital Second Fiscal Quarter 2021 Earnings Conference Call. Today's conference is being recorded. [Operator Instructions] It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer at 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 2021 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 a property of PennantPark Floating Rate Capital, and that any unauthorized broadcast of this call in any form is strictly prohibited. Audio replay of the call will be available by using the telephone numbers and PIN provided in our earnings press release as well as on our website. I'd also like to call your attention to the customary safe harbor disclosure 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 how we fared in the quarter ended March 31, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, then open up for Q&A. We are pleased with our performance this past quarter. We achieved another substantial increase in NAV during the quarter. Adjusted NAV increased 2.3% from $12.32 to $12.60, and our portfolio continued to improve. We have several portfolio companies in which our equity co-investments have materially appreciated in value as they are benefiting from the economic recovery. This is solidifying and bolstering our NAV. Over time, rotation of that equity into debt instruments should help grow PFLT's income. We will highlight those companies in a few minutes. As part of our business model, alongside the debt investments we make, we selectively choose to co-invest in the equity side-by-side with the financial sponsor. Our returns on these equity co-investments have been excellent over time. Overall for our platform from inception through March 31, our $226 million of equity co-invests have generated an IRR of 28% and a multiple on invested capital of 2.9x. In a world where investors may want to understand differentiation among middle market lenders, our long-term returns on our equity co-investment program are a clear differentiator. As a result of the completion of the CLO financing at PSSL last quarter, we can efficiently grow the joint venture, which should generate additional income for PFLT. PSSL's assets grew by $103 million during the quarter ended March 31 and has capacity for an additional approximately $100 million of assets over time. This growth can be a substantial driver of NII. The combination of potential income growth from equity rotation, a larger, more efficiently financed PSSL and a growing, more optimized PFLT balance sheet should help grow the company's net investment income relative to the dividend over time. Those factors, combined with strong portfolio performance through COVID and our $0.22 spillover as of September 30, have led us to conclude that we will be keeping our dividend steady at this point. We are also pleased that we diversified our financing sources this past quarter with the issuance of $100 million, a 4.25% 5-year senior notes to institutional investors in late March. Although we never predicted a global pandemic, as you may know, we've been preparing for an eventual recession for some time. Prior to the COVID-19 crisis, we proactively positioned the portfolio as defensively as possible. Since inception, we have had a portfolio that was among the lowest risk in the direct lending industry. As of March 31, average debt-to-EBITDA on the portfolio was 4.2x. And the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3x. This provides significant cushion to support stable investment income. These statistics are among the most conservative in the direct lending industry. We have only 2 nonaccruals out of 104 different names in PFLT and PSSL. This represents only 3.1% of the portfolio at cost and 2.3% at market value. We have largely avoided some of the sectors that have been hurt the most by the pandemic such as retail, restaurants, health clubs, apparel and airlines. PFLT also has no exposure to oil and gas. The portfolio is highly diversified with 100 companies and 41 different industries. Our credit quality since inception over 9 years ago has been excellent. Out of 381 companies in which we have invested since inception, we have experienced only 13 nonaccruals. Since inception, PFLT has invested over $3.9 billion at an average yield of 8.1%. This compares to a loss ratio of only 8 basis points annually. 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 investing at that time. During that recession, the weighted average EBITDA of our underlying portfolio companies declined by 7.2% at the bottom of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%. We're proud of this downside case track record in the prior recession. Based on tracking EBITDA of our underlying companies through COVID so far, we believe that our EBITDA decline will be substantially less than it was during the global financial crisis. Many of our portfolio of companies are in industries such as government services, defense, health care, technology software, business services and select consumer companies that are less impacted by COVID and where we have meaningful domain expertise. We believe that we are experiencing an economic recovery with some companies and industries being beneficiaries of the environment. We are pleased that we have significant equity investments in 3 of these companies, which can substantially move the needle in both NAV, and over time, net investment income. I'd like to highlight those 3 companies. They are Cano, Walker Edison and By Light. Cano Health is a national leader in primary health care who's leading the way in transforming health care to provide high-quality care at a reasonable cost to a large population. Our equity position has a cost and fair market value on March 31 of $431,000 and $9.1 million, respectively. We believe there's a massive market opportunity for Cano to grow in the years ahead with the Medicare Advantage program. The merger with Jaws Acquisition is currently scheduled to close in June. At that time, we will receive another $800,000 of cash and own 825,274 shares of Cano Health in a limited partnership controlled by a financial sponsor, where the sponsor will earn 20% of the exit proceeds. The shares will be locked up for 6 months. From a valuation perspective due to the lockup, the independent valuation firm valued the position with a 6% illiquidity discount to the traded value on March 31. Walker Edison is a leading e-commerce platform focused on selling furniture exclusively online through top e-commerce companies. As of March 31, our equity position had a cost of $1.4 million and a fair market value of $12.1 million. Shortly after quarter end, the company executed a refinancing and dividend recap, which resulted in shareholders receiving approximately 2x their cost while maintaining the same ownership percentage in the company. This resulted in PFLT receiving a $2.8 million cash payment on its equity position. By Light is a leading software, hardware and engineering solutions company focused on national security challenges across modeling and simulation, cyber and global defense networks. Our position has a cost of $2.2 million and a fair market value of $11.8 million as of March 31. All 3 of these companies are gaining financial momentum in this environment, and our NAV should be solidified and bolstered from these substantial equity investments as their momentum continues. Over time, we would expect to exit these positions and rotate those proceeds into debt instruments to increase income at PFLT. The outlook for new loans is attractive. We are focused on the core middle market, which we generally define as companies with between $10 million and $50 million of EBITDA. We like the core middle market because it is below the threshold and does not compete with a broadly syndicated loan or high yield markets. As such, we do not compete with markets where leverage is higher, equity cushion lower; covenants are light, wide or nonexistent; information rights are fewer; EBITDA adjustments are higher and less diligent; and the time frame for making an investment decision is compressed. On the other hand, where we focus, in the core middle market, because we are not competing with a broadly syndicated loan or high yield markets. Generally, our capital is more important to the borrower. As such, leverage is lower; equity cushion higher. We have quarterly maintenance covenants, which are real. We receive monthly financial statements to be on top of the companies. If there are EBITDA adjustments, they are more diligent than achievable. And we typically have 6 to 8 weeks to make thoughtful and careful investment decisions. According to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate and higher recovery rate than those loans to companies with higher EBITDA. We also believe that middle-market lending is a vintage business. This upcoming vintage of loans is likely to be the most attractive we've seen since the 2009 to 2012 time period, which was the time period after the global financial crisis. This vintage is characterized by leverage levels that are lower; equity cushion higher; yields are higher and the package of protections, including covenants, are tighter. After about 5 years of a late-cycle market for middle-market lending, it is refreshing to have an attractive risk/reward available to us. Let me now turn the call over to Aviv, our CFO, to take us through the financial results in more detail.

Thank you, Art. For the quarter ended March 31, net investment income was $0.26 per share. Looking at some of the expense categories, management fees totaled about $3.9 million. Taxes, general and administrative expenses totaled about $800,000, and interest expense totaled about $4.8 million. During the quarter ended March 31, net unrealized appreciation on investment was about $12 million or $0.29 per share. Net realized gains were about $500,000 or $0.01 per share. Net unrealized depreciation on our credit facility and notes was $0.27 per share. Net investment income was lower than the dividend by $0.02 per share. Consequently, GAAP NAV went from $12.70 to $12.71 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.60 per share, up 2.3% from $12.32 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 spillover as of September 30 was $0.22 per share. We have ample liquidity and are prudently levered. Our GAAP debt-to-equity ratio was 1.2x, while GAAP net debt-to-equity after subtracting cash was 1.1x. Regulatory debt-to-equity ratio was 1.3x, and our regulatory net debt-to-equity ratio after subtracting cash was 1.2x. With regard to leverage, we have been targeting a debt-to-equity range of up to 1.5x. We have ample liquidity to fund revolver draws, and we are in compliance with all of our facilities at March 31. We have readily available borrowing capacity and cash liquidity to support our commitments. We have a strong capital cost structure with diversified funding source and no near-term maturities. We have $400 million revolving credit facility maturing in 2023 with a syndicate of 11 banks, with $147 million drawn as of March 31, $118 million of unsecured senior notes maturing in 2023, $228 million of asset-backed debt associated with PennantPark CLO 1 due 2031 and our newly issued $100 million of unsecured senior notes maturing in 2026. Our portfolio remains highly diversified with 100 companies across 41 different industries. 86% is invested in first-lien senior secured debt, including 12% in PSSL, 3% in second-lien debt and 11% in equity, including 4% in PSSL. Our overall debt portfolio has a weighted average yield of 7.6%. 98% of the portfolio is floating rate, and 84% of the portfolio has a LIBOR floor. The average LIBOR floor is 1%. 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 instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders. In closing, I'd like to thank our extremely talented team of professionals for their commitment and dedication. Thank you all for your time today and for your investment and confidence in us. That concludes our remarks. At this time, I'd like to open up the call to questions.

[Operator Instructions] The first question comes from Mickey Schleien with Ladenburg.

Art, you mentioned the advantages of structures in the middle market versus the broader loan market, and I completely agree. And obviously, the broader loan market is very frothy at the moment. Are you seeing that volume is starting to trickle down into the middle market? And how is that affecting your ability to close deals?

It's a great question, Mickey. Look, it's -- the market has been remarkable in terms of how it's bounced back. Certainly, we've seen in the broadly syndicated loan and high-yield market and how it's related to the upper middle market, which we call the upper middle market above 50 of EBITDA. We're not quite back to where we were pre-COVID yet in the below 50 EBITDA zone. But certainly, as the economy continues to recover at some point, in the not-too-distant future, it will be back to where it was pre-COVID, which -- so we think, number one, the vintage right now is good. We should be capturing the vintage the best we can with high-quality companies, good structures and taking advantage of 2021. And to the extent the market continues to rebound, to some extent, it's back to the future. We need to continue to be very diligent and careful about what we invest in. As you know, with PFLT, we've always had a very defensive mindset, capital leverage levels low and reasonable and willing to prioritize capital preservation over yield, which has been a good thing for PFLT, PFLT shareholders over time. And where PFLT is positioned is kind of we want to be among the lowest-risk BDCs, willing to accept a lower reward, but having us and our investors feel very strongly about the capital preservation attributes. One of the nice things we get in the below 50 of EBITDA space is we get these equity co-invest to the extent we want them. And to us, those are separate investment decisions, but those equity co-invests have been very helpful over time in terms of creating some additional return, helping fill in the gaps for losses, et cetera. So we only have an 8 basis point annualized loss ratio. Part of that is due to the power of these equity co-invests. So we're not back to where we were yet. If things continue, inevitably, we may be. Let's capture the opportunity today while we have the opportunity. And then let's continue to have -- execute what has been a good track record, now nearly 10 years. We're coming up on our 10-year anniversary here. So I don't know if I answered your question, Mickey, but...

That's fine, and congrats on the 10-year anniversary. Art, how would you characterize then, given what you just said, the prepayment risk in the portfolio, just again considering that the broader market's frothiness? And how much call protection do you typically get in your deals?

Yes. So look, the market is active, and that's good news and bad news, right? The bad news is when the market is active, high-quality credits get taken out. Sometimes companies are sold. Sometimes they can access the broadly syndicated loan market at a lower yield. That's the bad news. The good news is we are -- when we do get paid off, we say thank you, and deal flow's heavy. So we can replace that and, over time, grow the portfolio because there is so much activity. And that's certainly the game plan here, grow PSSL to the tune of about another $100 million, grow PFLT on balance sheet over time up to the 1.5x debt-to-equity and then, of course, rotate those equity investments. So we've never had a difficult time ramping and still finding high-quality deals to fit our box. It's because we have such good relationships and calls have been around so long relative to, I'll call it, medium-sized relative to our capital. The origination flow relative to our capital is usually very robust. So we've never had a challenge ramping over time. These deals do take longer. These are fully diligent, fully negotiated 6- to 8-week processes where we negotiate covenants. So it's not like we can turn around and flip on a switch and ramp overnight. But we are very active and do see an opportunity to grow the portfolio. In terms of call protection, as you know, typically, we're buying these loans at $0.98 or $0.99 on the dollar, original issued discount, which we do not account for as upfront fee. We amortize that original discount over the life of the loan. Typically, we'll have -- get 1 0 2 or 1 0 1 in the first couple of years. And the best part of -- the best call protection we can have for the really good deals is those little equity co-invests, which continue to generate value even when the debt is called out. So that's -- and we've seen that with some of these wins like Cano. Cano, we're not in debt anymore. The company refinanced this out of the debt in the broadly syndicated loan market, but we have a very valuable equity co-invest. Walker Edison, we have valuable co-invest. By Light, we have a valuable co-invest. So that's the way we have a tail, and that's the way we continue to have upside on these deals.

Okay. I understand. And one just last sort of housekeeping question for you or Aviv. Could you just highlight what were the main drivers of the unrealized depreciation on investments?

Finally...

Go ahead. Go ahead, Aviv, please.

Yes. Certainly, some of the large movers, if you look at quarter-over-quarter, you have DBI Holding improved about $0.09 per share quarter-over-quarter. The PSSL JV, it's mark-to-market because it's a robust first-lien portfolio, and there is about $0.07 or so. And on the negative side is Country Fresh. Its mark-to-market went down about $0.09 quarter-over-quarter. So net-net, it's kind of what you see the large movers.

We will now take our next question from Paul Johnson with KBW.

Kind of on the lines along Mickey's question with competition in the middle market, I'm curious -- I know you talked to this a little bit. But just -- I mean, have you guys seen any pressure on covenants or LIBOR floors compared to, I guess, sort of the pre-COVID vintage from any sort of competition as the market recovers?

Yes. So on the covenant side, we've -- we're getting tighter covenants than we did pre-COVID. So that's good for now. And again, we get these quarterly maintenance tests. And we get the monthly financial statements, which are our differentiator in our kind of below $50 million of EBITDA world. What was the second part of your question, Paul? Covenants and...

The LIBOR floors.

LIBOR floors, yes. So when there is a little bit of pressure, in certain cases, you get pressure to push it down to 75 basis points from 100 basis points. So that all depends. That could be good news or bad news. It depends on your going-in yield and your spread. I guess the good news about the lower floor is that if and when LIBOR goes up, inevitably it will, we'll start capturing more upside sooner than if LIBOR floor stays at 100. In certain cases, we've had LIBOR floors higher. We had a recent deal where the LIBOR floor was 150. So it's deal by deal. It's kind of a dynamic you negotiate. And it just depends on the particular deal and what the situation is. So we've seen it go both directions. The LIBOR floor in 90-plus percent of cases is still 1%.

Okay. That's good color. And then I guess kind of along similar lines, I mean do you guys see any difference for those same reasons, just competition growing, maybe not so strong yet in your sort of market below $50 million EBITDA. But do you see any pressure at all that would make you view the difference, I guess, an opportunity set between loans on the balance sheet versus investments in the JV?

No. I mean it's still the same group of competitors. There's not -- like in our world, there's no like new people, new money that's -- has cash burning a hole in their pocket, and it's just kind of changing the risk/reward spectrum. It's the same characters -- same people we compete with. One day, we're competing with them. The next day, we're in a club with them. So it's the -- I'll call it the usual suspects. So generally, those usual suspects are relatively rational in how they're behaving. So we're not seeing any exogenous kind of movement.

Okay. And the last question, I guess, was just around the equity co-investments. I'm just kind of curious, I mean, obviously, again, market's getting more competitive. Have you seen any change in terms of your ability to receive equity co-investments from any of your portfolio of companies? Has this changed at all? Is sponsors, I guess, less willing to give equity at all? Or is it just really no change and kind of a case-by-case basis?

Yes. It's more case by case. And with us, it's case by case, too. We don't automatically always say we want the equity when we're doing the debt. For us, it's a separate investment decision. So in some cases, we'll like the debt, and we'll graciously decline the co-invest even if it's offered. In other cases, we may fight hard to do more co-invest. So for us, the equity co-investment is a separate investment decision, needs to stand on its own 2 feet as an investment decision. And there's no difference in behavior. It's -- again, it's case by case, idiosyncratic based on the sponsor, based on the deal, the deal dynamics. And it's something that as we look over the last 14 years of our business that, by and large, has worked out really well as we're looking at the opportunity set over 14 years now through the global financial crisis, through COVID now. A 2.9x multiple invested capital says -- in general, it's something that we think should be part of most of these portfolios. Obviously, you could do some bad equity co-invest. You can do some really good equity co-invest. But by and large, the good ones have way outperformed the bad ones. You get the Canos or the By Lights or the Walker Edison or some of these, your -- those can be very powerful add-ons to the portfolio. And by the way, you don't get those -- for the folks who are doing direct lending with companies above 50 of EBITDA, 100 of EBITDA or whatever, that's generally not part of the mix. So that is a benefit you get in the kind of below 50 EBITDA world that we [ traffic in ].

We will take now our next question from Devin Ryan from -- with JMP Securities.

Okay, great. So first one, I guess, just to follow up on the last conversation, and these are just a couple of follow-ups. On the equity co-invest, given kind of your track record and experience in the portfolio over more than a decade, is now a time to lean in there? I appreciate it's opportunistic and idiosyncratic. But as you've kind of looked back over history, your markets are strong right now and clearly a lot of momentum. Same time, valuations are high. So I'm just kind of curious how you guys are thinking about the risk/reward in that. And I know it's not a general comment, but I'd love a little bit more color there.

Yes. That's a great question. And we're typically not the type to say now is or isn't the time. It's kind of a bottoms-up deal-by-deal approach. We do have to obviously look at the economy and what's going on in the economy. And of course, the economy is recovering quite nicely. What drives our equity co-invest decisions and where we're a little bit more aggressive are either 2 facts. Fact A, the valuation is very attractive. The enterprise value to EBITDA is attractive relative to the comps or the peers or low relative to the cash flow that we think is going to be generated. So classic value investing. So if the value is very attractive, that will be something we'll prioritize. And conversely or as an adjunct, and maybe this is having taken easy too, when we see a very strong growth trajectory, that can be very attractive to us. Our typical -- our prototypical deals we're doing these days are where a sponsor identifies a sector where they think growth is going to be high. It's a fragmented industry that can do add-on acquisitions or there's secular win behind it. And they buy a platform with $10 million or $15 million of EBITDA that they want to grow to $20 million, $30 million, $40 million, $50 million, $100 million of EBITDA either through add-on acquisitions or just organic growth. And generally, that's pattern. And our debt capital, by the way, is going to fuel that, right? So the capital commitment we're making is going to fuel that move from $10 million to $15 million of EBITDA to $50 million to $100 million. And therefore, we're -- we have a front-row seat on seeing the growth. And therefore, they know we're fueling the growth with our debt. They're generally more than happy to share the equity co-invest with us. And that's kind of our prototypical deal these days. That's where that kind of fits our box perfectly. That's Cano. That's Walker Edison. That's By Light. That's over PNNT. That's Wheel Pros. That's kind of where if you want to look at a prototypical PennantPark deal these days, and it's going to be in industries that we know and like that are high free cash flow industries where we can be among the smartest people in the room with the domain expertise, that's kind of our bread and butter. So take it from $10 or $15 million of EBITDA, have the debt fill it to $40 million or $50 million or greater, ride the equity co-invest, and the equity co-invest could be a nice upside. Cano, the example is they took us out -- they took the debt out with the broadly syndicated loan. But we still have a very attractive co-invest that we're writing. Walker Edison just did a dividend recap. We still have the equity there. So you can look at these deal by deal by deal. That's where we've had very nice strong track records. So I don't know if that really shed light on how we look at equity co-invest and how we look at our business, but that's kind of what we're doing these days.

Yes. No, that's great context. I appreciate that. Just a follow-up here on the PSSL JV. Obviously, great growth there and compelling for shareholders. As you look ahead and think about that incremental $100 million or so of capacity, how should we think about timing? And is it reasonable to think that you could kind of get there over the next 1 or 2 quarters? Or any other context you can give us would be helpful.

Yes. I'd say probably 2 to 3 quarters on optimizing PSSL.

And as there are no further questions in the queue, I would like to hand the call back over to Art Penn for any additional or closing remarks.

Thank you, everybody. Thanks for your time today. We really appreciate your interest. We wish you continued good health, hopefully as we come out of COVID. And looking forward to speaking to you all in early August on our next quarterly earnings call. Thank you very much.

Thank you. This concludes today's conference call. Thank you for your participation, ladies and gentlemen. You may now disconnect.