PennantPark Investment Corporation (PNNT) Q2 2012 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the PennantPark Investment Corporation’s Second Quarter 2012 Results Conference Call. As a reminder, today’s call is being recorded. [Operator Instructions] At this time, I would like to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Please go ahead.

Thank you, and good morning, everyone. I’d like to welcome you to our second fiscal quarter 2012 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 the 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 Investment Corporation 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. 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 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.

Thank you, Aviv. I’m going to spend a few minutes discussing current market conditions followed by discussion of investment activity, the portfolio, our overall strategy, and then open it up for Q&A. As you all know, the economic signals have continued to be mixed to slightly better with many economists expecting a flat to slightly growing economy going forward. With regard to the more liquid capital markets and in particular the leverage loan and high yield markets, those markets have rallied this year so far as cash flows in the high yield funds, leverage loan funds, and CLOs has been strong. Risk reward in the middle market has remained attractive, as the overall supply of middle market companies who need financing exceeds the relative demand of applicable lending capacity. As debt investors and lenders a flat economy is fine, as long as we’ve underwritten capital structures prudently. A healthy current coupon with de-leveraging from free cash flow over time is a favorable outcome. We remain focused on long-term value and making investments that perform well over several years. We continue to set a high bar in terms of our investment parameters and remain cautious and selective about which investments we add to our portfolio. Our focus continues to be on companies or structures that are more defensive, have low leverage, strong covenants, and high returns. With significantly reduced competition in the middle market, we have taken advantage of the 2009 through 2011 vintages. The 2012 vintage should remain solid. With plenty of dry powder, we are well positioned to take advantage of the market opportunity. As credit investors, one of our primary goals is preservation of capital. If we preserve capital, usually the upside takes care of itself. As a business, one of our primary goals is building a long-term trust. Our focus is on building long-term trust with our portfolio companies, management teams, financial sponsors, intermediaries, our lenders and of course our shareholders. We are first call for middle-market financial sponsors, management teams, and intermediaries who want consistent credible capital. As an independent provider, free of complex or affiliations, we’ve become a trusted financing partner for our clients. As the market has gone more active, we are completing more transactions for well regarded financial sponsors with whom we have had long-term relationships. Since inception, PennantPark entities have financed companies that buy over 100 different financial sponsors. We have been active and are well positioned. For the quarter ended March 31, 2012, we invested about $111 million with an average yield on debt of 13.2%. Expected IRRs generally range from 13% to 18%. Core net investment income was $0.28 per share. Core net investment income excludes one-time expenses of $0.10 per share related to the upfront fees on our new credit facility. We have met our goal of a steady, stable and growing dividend stream since our IPO over five years ago, despite the overall economic and market turmoil throughout that time period. We renewed our credit facility on attractive terms. The facility is $380 million, has a four-year maturity with a one-year term-out after year three and is priced at LIBOR plus 275. We appreciate the support and long-term partnership of the lending community to our company. To enhance our liquidity to take advantage of opportunities in the market, in late January, we raised $105 million of net proceeds in equity offering. Incremental float on liquidity in our shares should continue to help attract investors to our stock. As a result of the focus on high-quality new investments, solid performance of existing investments 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 continue to be healthy at 2.8x. This provides significant cushion to support stable investment income. Additionally, at cost, the ratio of debt-to-EBITDA on the overall portfolio was 4.9x, another indication of prudent risk. The structure of our investments in the portfolio was relatively low risk. It consists primarily of cash paid debt instruments and only 9% of the portfolio is preferred and common equity. We have plenty of liquidity. As of March 31, we had in total about $270 million of available liquidity, which included $220 million available under our credit facility, about $25 million of assets with coupons less than 9%, which we intend to continue selling and rotating into higher yield investments, and $26 million of cash in our SBIC. We continue to grow our SBIC and Aviv will give an SBIC update later. We are looking forward to applying for a second SBIC license when appropriate, to be able to access up to another $75 million of debt capital. As a reminder, we have exempted relief from the SEC to exclude SBIC debt from our asset coverage ratios and SBIC accounting is cost accounting not mark-to-market accounting. These facts highlight how the SBIC debt reduces overall risk of the company. We had some attractive realizations last quarter. Our $17 million debt position in VPSI was refinanced and generated an IRR of 16.5%. We generated a 16.8% IRR on our debt position in RAM Energy when it was refinanced. Chester Downs refinanced its senior debt and we generated an IRR of 16.5% on that position. Despite the recession, PennantPark entities have had only five non-accruals out of 183 investments since inception five years ago. To refresh your memory about our business model, we try as hard as we can to avoid mistakes, but the faults and realized losses are inevitable as a lender. We are proud of our track records of underwriting credit through the cycle. One way we mitigate those loses is through our equity co-investment portfolio. We are optimistic that our co-investment portfolio, which includes names such as TriZetto, CT HealthPort, Magnum Hunter, Kadmon, and Veritext, will generate gains over time. From an interest rate standpoint, 7% of the portfolio has an interest rate that floats, another 27% floats, but has a floor, which protects income in this low base rate environment and the remaining 66% is fixed rate. In terms of new investments, we had another quarter investing in attractive risk adjusted returns. Our activity was primarily driven by M&A deals and virtually all of these investments, we have known these particular companies for a while, have studied the industries, have a strong relationship with the sponsor or have differentiated information flow. Let’s walk through some of the highlights. We invested $19 million in the subordinated debt and $2 million in the equity of Acentia. Acentia is a leading provider of information technology solutions to the government and healthcare markets. Snow Phipps is the financial sponsor. Galls is leading distributor of public safety, private security and defense products. We invested $21.5 million of subordinated debt and $1.5 million in the equity of this company, which is backed by CI Capital. We invested $11.5 million in the senior secured debt of IDQ. IDQ is a provider of air conditioning maintenance and repair solutions for the DIY auto aftermarket, Castle Harlan is the sponsor. Paradigm Management is a provider of catastrophic and pain management services to injured workers. We invested $20 million in the second lien debt and $2 million in the common equity in this company, which is sponsored by Lightyear Capital. We invested $15 million in two layers of first lien debt and $2 million in the common equity of Tekelec Global. Tekelec is a global provider of software solutions for telecommunications and cable companies. Siris Capital is the financial sponsor. Turning to the outlook, we continue to believe that the remainder of 2012 will be active. We are seeing a significant amount of middle-market M&A, which over time should drive a substantial portion of our investment activity. Due to our strong sourcing network and client relationships, we are seeing strong 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, 2012, investment income totaled $26.4 million, expenses totaled $11 million and one-time non-recurring, non-taxable expenses totaled $5.4 million. The one-time expense related to the upfront fees and expenses from our renewal of the credit facility. Management fees totaled $6.6 million. General and administrative expenses totaled about $1.7 million. SBA and credit facility interest expense totaled about $2.7 million. Accordingly, net investment income was $9.8 million or $0.18 per share. Core net investment income, excluding one-time expenses was $15.1 million or $0.28 per share. During the quarter ended March 31, net unrealized gain from investments was approximately $21 million or $0.39 per share. Net realized loss was $3.9 million or $0.08 per share, and dividend in excess of net investment income was approximately $6 million or $0.12 per share. Consequently, earnings per share went from $10.19 to $10.38 per share. As a reminder, our entire portfolio and our credit facility are mark-to-market by our Board of Directors each quarter using the exit price provided by an independent valuation firm or independent broker/dealer quotations when active markets are available under ASC 820 and ASC 825. In cases where broker/dealer quotes are inactive, we use independent valuation firms to value the investments. Our overall debt portfolio has a weighted average yield of 13.3%. On March 31, our portfolio consisted of 49 companies and was invested 30% in senior secured debt, 19% in second lien secured debt, 42% in subordinated debt, and 9% in preferred and common equity. Our SBIC has drawn the maximum amount, $150 million of SBA debentures, and we have $26 million of cash available as of March 31. We feel fortunate to have locked in the entire $150 million at a fixed all-in rate of 4% for a 10-year when treasuries were near all-time low. We are exploring, applying for a second SBIC license when appropriate, which would result in up to additional $75 million of SBA loan. As of March 31, undistributed taxable net investment income in excess of dividend paid was approximately $6.8 million or $0.12 per share providing cushion for future dividends. 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 growing dividend stream. 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 debt instruments, and payout 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 continued investment and confidence in us. That concludes our remarks. At this time, I would like to open the call to questions.

[Operator Instructions] We’ll take our first question from Greg Mason with Stifel, Nicolaus.

Art, you’ve actually had some large equity gains in some of your equity positions, like EnviroSolutions, Kadmon, and VText, Magnum Hunter. What is your ability to affect the exits of those equity investments and potentially redeploy them into more debt yielding investments?

Greg, that’s a great question. In a couple of them, we do have more control. For instance, Magnum Hunter is a public stock, though we can sell that at any time, we’re choosing to hold on to that because we think there is a lot more upside to that particular name. EnviroSolutions, ESI, we are one of the three control shareholders. We sit on the Board of that company. To refresh your memory that was a first lien position that converted to equity through a restructuring. So it’s not a liquid stock, but we are one of the three control shareholders and we will obviously have a seat at the table on the exit, and when the exit happens there -- and there has been some activity in the waste collections business recently in the M&A world, which is interesting. And then the other names that you’ve mentioned are equity co-invest where we are co-investing on the side-by-side typically with a financial sponsor. So, we are not in control positions there. We are along for the ride, and when the exit happens, it happens. But you see names like this quarter we had VPSI. VPSI, the debt was refinanced this quarter because the company has been doing very well and our equity co-invest remains side-by-side with the sponsor. And we like having some of these equity co-invest to have some lift in the portfolio, have some securities that have some lift. And also when we do get called out and usually you get called out on your good deals, we have a tail, we have an ongoing tail to make money on the good deals. So, that’s kind of the logic behind it.

Okay, great. And then could you talk about the SBIC process given you’ve drawn a $150 million, what is the reason for waiting to file for the second license, is there any guidance from the SBA or what are you waiting on for the second license application?

Yeah, everything is going fine, we are a relatively new entrant to the program. The SBA is probably not used to the speed with which BDCs can deploy capital. So, we’ve been led to believe that since we are relatively new, we should give it some time, have the portfolio mature a little bit, have them see our performance before we come back for round two, which makes good sense from their standpoint, that’s prudent investing from their standpoint. And we are going to be in continual dialogue with them to work collegially to, you know when we can come back for a license two.

Okay, great. And then one final question, kind of the one concerned in your portfolio, UP had an additional write-down this quarter and it looks like the pick rate increased. Can you talk to us, give us some comfort with that investment, it’s not on non-accrual yet, can you just talk about what’s going on there?

Yes, so UP is you know, is on heavy watch from our standpoint, part of it as we discussed last time was the delay on the Keystone Pipeline. Keystone pipeline is a big customer of UP as you may know from reading the paper, that’s been on delay. So that has hurt this company. There are some other things going on with the company. So we are spending a lot of time, focused on it and doing due diligence to try to figure out what’s going on, but we thought it was prudent and judicious for us to mark it down this quarter.

We’ll take our next question from Joel Houck with Wells Fargo.

Art and Aviv, just kind of a broad market question here, obviously, the spreads are continuing to tighten in covenants I guess overall in the middle-market are loosening a bit, you guys are still regenerating strong yield relative to what we’ve seen out of your peers. Maybe talk a little bit about the characteristics of the deal flow you are seeing and how that’s changed if any over the last several months?

You are making a good point, as you read the newspapers and see what’s going on in the bigger more liquid markets due to cash flows and to high yield and leverage to our mutual funds the more liquid markets have rallied substantially as we said, yields have gotten compressed, there are some deals that are starting to pop up again that are coming in light. So the bigger more liquid markets have certainly rallied, to refresh your memory in the middle-market, which is where we play, we are away from that fray, the middle-market because it is less liquid or illiquid tends to be much more stable. And we have not seen some of that aggressiveness yet flow into the middle-market. But look, as always you have to remain vigilant, if we like a market as buyers where people are a little fearful and right now there is general consensus that the U.S. economy is doing fine and again we are seeing good risk rewarded in the middle-market. Our average kind of mezz deal is 4.5 times we are getting a 13% to 14% yield on it, decent upfront, two, three point fees, equity co-investment. I mean that’s a typical mezzanine deal in today’s market and that has not changed. But we always have to remain vigilant and to the extent people lose their fear. We’ve got to be smart enough to pull back and play more defensively, but thankfully, at this point, we don’t see that. Looks like the ’12 vintage should to be pretty good, still in kind of the mid-fours type leverage level and we are excited about going after that.

Okay, good. And then switching gears more on capital structure question. With the new facility you have in place, what do you consider kind of the target leverage level in this environment and how soon you expect to get to that level?

I mean target leverage -- we are consistent with everyone we talk to, as we target 0.6x to 0.8x. We think that’s a fine target, 0.6x to 0.8x debt to equity. Leaves us with plenty of cushion even in a downside case; as you know, we have extra cushion because of the SEC exemption of our SBIC facility and how that has carved out. So, we could take it substantially above 0.6x to 0.8x. Again, we are not targeting to do that, but again, that’s extra cushion and extra safety for the company and for our shareholders. And in terms of when we’re going to get to that target, Joe, you know we never answer that question because we don’t think that way. We don’t think about what our target origination is this quarter or next quarter or the other quarter. Sometimes we have pretty heavy origination quarters like we had this past quarter. Sometimes, we have light quarters like we had the prior quarter. Our discipline is to come in everyday and look at the deals in front of us today to figure out if the deals are good. If that deal today is a good deal, if there is a good deal to do today, we’ll do it. And sometimes that results in very active quarters and sometimes that results in very inactive quarters. So, we’re just taking our growth organically. It’s all based on individual deal by individual deal. We have found that being a forced buyer has been a bad thing for BDCs in general. It’s important to maintain your discipline and we also think being a forced seller is a bad thing too. So, we try to setup our business to take a deal by deal and try to make each investment a good investment and the growth -- if there is growth, it will be organic.

Okay. And I guess an add-on to that is, are there other types of debt you might be considering to further diversify your liability structure? We’ve seen a number of BDCs do term debt deals, baby bond deals, whatever you want to call it. At the current pricing, given peoples expenses structure, they don’t seem all that accretive. I am wondering what’s your take on it is and if you think that something Pennant might do?

Yeah. There is no current plans to access one of the alternative debt markets. It is by the way, it’s really great that BDCs have different sources of capital, the advent of the baby bond market, the advent of the convert market, a private placement to insurance company market. It’s great to have all different flavors. And over time, we do think it’s prudent to diversify our funding sources and why you diversify your funding sources even if it is more expensive and we do think those forms of debt, all of them, are certainly much more expensive than our revolver and more expensive than our SBIC facility. So it’s not something you would do lightly. The only reason you would do it is basically if you’re paying an insurance premium in the form of an increased yield to have diversified funding sources and alternative and unsecured funding sources in the event of a down cycle. In down cycles, and you can remember ‘08, ‘09 time period. There were some BDCs that had some senior lenders that really forced them to sell assets at exactly the worst time and you don’t have to do that if you have bonds, right? If you have either baby bonds or converts or private placements generally, you don’t become a forced seller at the worst time. And that’s the reason someone would pay the -- essentially insurance premium of an incremental coupon on these forms of debt to diversify their funding sources. So that if there is a downside case, the shareholders are protected during that case. And so like anything, it’s kind of like is the insurance premium you are paying worth it and of course it is, if there is an event and it isn’t, if there isn’t. But over time, we think it will be prudent to judiciously tiptoe into some of these alternative markets really because again, we want to protect the company and the shareholders for the downside case.

We’ll take our next question from John Stilmar with SunTrust.

Avi, it’s just a little bit more of a longer term question. Now just going back through kind of your portfolio investments may be a year and then two years ago, Pennant’s grown its balance sheet pretty meaningfully, but one of the things that’s striking to me is the fact that despite Pennant’s balance sheet getting bigger, the average hold size or at least portfolio concentration has still remained below 5%. As we start thinking about Pennant in the years to come, how do you think about portfolio diversification versus kind of relevance to financial sponsors and when you think about constructing your portfolio, I’m wondering if you can take us through your thought process as we just kind of put Pennant in kind of a longer term strategic perspective?

It’s a great question. And hopefully people have gotten the flavor in this call and other calls. We are trying to be at very low risk or as low of possible risk BDC. We are focused on very stable and hopefully growing dividend stream, protecting the NAV and one way to reduce risk and an important way to reduce risk is diversification. We do believe in highly diversified portfolio, 5% would be a big position for us, we can do it, but our general preference is to have positions that are 2% or 3% of the portfolio, that’s our general safety zone, because you know what, we do make mistakes. We try as best we can to underwrite perfectly, inevitably, we will make mistakes and we don’t want any one or two or three mistakes, really to harm the company or harm the safety of the company. So we are big believers in diversification as a way to mitigate our risk targeting a 2% to 3% average bite size as kind of the middle of the Bell curve, every once a while there might be a 4%, maybe a 5% if we absolutely love it and there will be obviously 1% and 2% positions, but generally we think of position sizes as 2% to 3%.

[Operator Instructions] We’ll take our next question from Mickey Schleien with Ladenburg.

Art, you mentioned the lumpiness of originations that’s certainly part of the BDC model. I wanted to get a sense at least over the last few quarters, what portion of your deal flow has been from the private equity sponsor channel versus other channels?

This past quarter as an example, it was -- all five deals were through the middle-market private equity channel where we had a relationship with the sponsor to the company. So, if you look at the portfolio overall is probably something like 90% is sponsored about 10% is not sponsored.

And of the 10% -- I’m sorry, of 10% that’s non-sponsored, is that primarily coming from business brokers or where does that lie?

On the non-sponsor, it will usually come from investment banks that focus on the middle-market; you were trying to raise capital for private middle-market companies. For sponsor less deals, it’s a bit of higher bar for us. Obviously, we like as lenders who are interested in safety having a big equity cushion beneath us. So, that before we lose a dime, we got someone with real skin in the game, not to say that sponsorless companies don’t have a lot of skin in the game, they do, but they are usually with management teams who are new to us and we need to have a higher bar and have a higher diligence bar to do it. So, we do it when the risk reward is good and where we structure something really attractive, but it’s not the primary mission of the company.

And given -- considering the high level of sponsored deals, are these relationships where you have some exclusivity in terms of the deal or are a majority of them auctioned?

Well, in some cases the sponsors are going through auctions and in a lot of cases they are going out to multiple financing sources. And sponsors come in all flavors as you might imagine. We tend to finance people we’ve developed trusted relationships with and we are only one of a couple financing providers around the table. If we walk in a room and there’s 10 other guys of our peers kind of sitting there next to us, we really question what our value add is. And it’s really about the less basis point, and if it is, what’s our real value add to our shareholders. So, you can see in our deals and in our sponsors list, we do have significant repeat business with people that we’ve known for in many cases decades, where there really is a trusted relationship. And we don’t begrudge our sponsor clients from showing the deal to other people. Of course, they should to make sure they’re getting a fair and market deal, but it should never be about the last basis point or last covenant tweek. If the number of people in the room is relatively small and we never are going to get a good bite out of it if we want it, we’ll -- and get a fair shot at it. That’s fine with us. And you know what, a lot of times we say, no. A lot of times, we walk into a management meeting, spend time with the management and say, thank you very much, deal is not for us, we appreciate it and therefore this sponsor should bring other people into the room. But we don’t really love the 10 people in the room, if it’s a couple two three guys, that’s certainly understandable.

We certainly don’t like to see 10 people in the room either in terms of as investors. Have you seen a shift in sponsor mentality, given that overall originations across the industry have been pretty solid, I mean they’re lumpy, but the deal flow is good, are sponsors getting more aggressive in terms of the number of people in the room on average?

Look, I’ll say, leopards don’t change their spots. With some people, it always is about the last basis point, with some people, it’s more about other things, and character and long-term trust. And you end up self-selecting, right, people end up self-selecting who they do business with.

Our last question will come from Bryce Rowe with Robert W. Baird.

Just one quick question here, did the debt offering cost from this quarter, does that affect the incentive fee for next quarter?

It reduced the incentive fee for this quarter, because our GAAP income was down. And so what would typically happen is and what we’ve done historically, the upfront fee would be amortized for tax purposes over the course of the life of the loan and for GAAP purposes. In this case, because we elected to do ASE A25, which used to be called FAS 159 and mark that credit facility to market, GAAP forces us to take it as a one-time fee upfront, which is why we had a $0.10 of share non-recurring one-time fee upfront, which reduced both GAAP income, as well as the incentive fee for this quarter. Going forward on a GAAP basis, we are not amortizing that $0.10 anymore that’s done and dusted and we’ve dealt with it this quarter. So from the standpoint of incentive fee, management took a reduced incentive fee this quarter upfront and we will get it back gradually over the three or four years of the loan.

And that concludes our question-and-answer session.

Great. Thanks everybody. I appreciate everyone’s interest today and looking forward to speaking to you all next quarter. Thank you very much.

Again, ladies and gentlemen, this does conclude today’s conference. We thank you for your participation. You may now disconnect.