PennantPark Investment Corporation (PNNT) Q4 2013 Earnings Report, Transcript and Summary

Good morning, and welcome to PennantPark Investment Corporation's Fourth Fiscal Quarter 2013 Earnings Conference Call. Today's call is being recorded. At this time, all participants have been placed in listen-only mode. The call will be opened 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 Investment Corporation. Mr. Penn, you may begin your conference.

Thank you and good morning everyone. I'd like to welcome you to PennantPark Investment Corporation's fourth fiscal quarter 2013 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 included 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 PennantPart 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 would like to turn the call back to our Chairman and Chief Executive officer, Art Penn.

Thank you, Aviv. I am going to spend a few minutes discussing current market conditions, followed by a discussion of investment activity, the portfolio, the financials, the overall strategy, and then open it up for Q&A. As you all know, the economic signals have continued to be mixed with many economists expecting a slowly growing economy going forward. With regard to the more liquid capital markets, and in particular the leveraged loan and high yield markets, those markets have generally been strong this year due to substantial cash flows into high yield funds, leveraged loan funds, and CLOs. Risk reward in the middle market has generally 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 slow growth economy is fine as long as we have underwritten capital structures prudently. A healthy current coupon with deleveraging from free cash flow over time is a favorable outcome. We have continued to be selective about which investments we make in this environment. Given our strong origination network and the size of our Company, we believe we can continue to prudently grow. We remain focused on long-term value and making investments that will perform well over several years and can withstand different business cycles. 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 plenty of dry powder, we are well positioned to take advantage of investment opportunities as they arise. As credit investors, one of our primary goals is preservation of capital. If we preserve capital, usually the…

Thank you, Art. For the quarter ended September 30, 2013, recurring net investment income totaled $0.23 per share. In addition, we had $0.03 per share of other income. As a result, net investment income for the quarter was $0.26 per share. Looking at some of the expense categories, management fees totaled $9.7 million, general and administrative expenses totaled $0.5 million, and interest expense totaled $4.1 million. During the quarter ended September 30, the net unrealized and realized gain from investments and debt was approximately $5.5 million or $0.08 per share. Excess dividend over net investment income was about $1.5 million or $0.02 per share. Consequently, NAV per share went from $10.43 to $10.49 per share. As a reminder, our entire portfolio credit facility and senior notes are mark-to-market by our Board of Directors each quarter using the exit price provided by independent valuation firms, securities exchanges or independent broker-dealer quotations when active markets are available under ASC 820 and 825. In case our booker-dealer quotes are inactive, we use independent valuation firms to value the investments. Our overall debt portfolio has a weighted average yield of 13%. On September 30, our portfolio consisted of 61 companies across 26 different industries and was invested 28% in senior secured debt, 33% in second-lien secured debt, 28% in subordinated debt and 11% in preferred and common equity. 48% of debt portfolio has a floating rate and the average LIBOR floor is 1.7%. 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, consistent 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 debt instruments and 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 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 Mickey Schleien with Ladenburg. Mickey Schleien – Ladenburg: I wanted to ask you about the fourth quarter deal flow. We're hearing that it might be quite busy and I'm curious about the quality of the deal flow, specifically are you seeing more M&A business as opposed to refinancings and repricings?

It's a great question. We are seeing some nice deal flow for the December quarter, and it is more in line with traditional mezzanine that's used for new buyouts or growth financings. So it's kind of back to what we would prefer, which is kind of down the middle of the fairway, middle-market financings for growth or buyouts, and the activity level is pretty good.

You increased the weighting in the portfolio into second-lien pretty significantly. Could you describe your current view of that segment and why that occurred?

We look at deal by deal. Clearly, all things equal, we like floating rate, we like that potential upside. If we do fixed rate, usually it's a high fixed coupon such that if the credit quality is good, that coupon looks very attractive to us over time. This was just what the market gave us, the opportunities in the market. Where we can negotiate a floating rate, we will. Where we can negotiate a second lien versus sub debt, we will. It really just is kind of a deal-by-deal situation, Mickey.

Okay. You have a couple of concentrated positions in the energy sector, Brand Energy and Eureka, is that also opportunistic or is there some overriding theme there?

We like energy as a space. Energy is a big sector of the economy. We think there's a lot of opportunity in energy. So we will continue to focus on energy as a key industry vertical for us. It's one place where the American economy is growing and where there are lots of capital needs going forward. So energy will continue to be an element of what we do. Just as an FYI, Brand Energy did announce that they were getting bought, and that deal that we had will be getting refinanced and taken out of their premium. But we do like energy, we think it's underserved by banks today in general and we think the opportunity for capital deployment is interesting.

Thanks Art. Just a couple of housekeeping questions and I'll let someone else jump in. In the K, it shows $15 million of undistributed taxable income at the end of the year. I just want to confirm that I'm reading that correctly because that's $0.23 a share, and in the previous quarter when we talked about it, it was only $0.01 to $0.03. So, I'm curious what caused that large increase from the third quarter to the year-end.

It's just a timing difference, Mickey, which is the dividend gets paid out right after quarter end. So you can look at it as $0.23 positive, you can look at it as about flat, it's just kind of timing.

Okay. And lastly, if I'm doing the math correctly, there was actually a credit to administrative expenses in the fourth quarter. I guess you were probably truing things up for the year, but I want to understand the nature of that, and more importantly, what's the outlook for administrative expense in the next fiscal year and is there some sort of operating leverage to consider there?

It is quite right. At year end, we're truing up or down as the case may be. So that's what you see as of September 30 in our fiscal year end. And for the next year guidance, if you look at the year-ending, 12-months ending September 30 of about $6 million, that will give you a good clue as to the next year as a running level of G&A.

Okay, thanks for your time this morning.

We'll hear next from Greg Nelson with Wells Fargo Securities.

This is Greg filling in for John. Just a couple of quick questions for you, Art. First, when we look at the environment and the excess liquidity that's flowing around, we see some equity gains this quarter in Magnum Energy. Just trying to get a sense of the future gains in the portfolio and what that can mean for NAV going forward.

In terms of kind of the benefit of some of the strength in the market, you are absolutely right, we are seeing some general NAV improvement. Post quarter end, there were two investments that have traded up very nicely. One is Affinion where that instrument was $0.57 on the dollar at 9/30, today it's trading in the mid 80s or quoting in the mid 80s. The other one is Instant Web first lien, that was quoted around $0.80 on the dollar at 9/30, today it's quoting in the mid-90s. So we have seen some appreciation in the portfolio, and that is the positive of this kind of gradual economic recovery that we're seeing. Some investments are starting to be valued higher, equity co-invest portfolio should be valued higher, you mentioned Magnum Hunter. So in this environment, where on one hand we can say, there's not enough fear in the market, we'd like more fear on one hand, on the other hand we're saying it's helping the NAV of the portfolio. So that is certainly part of the positive we're seeing.

Great, thanks. And then just another quick one. Going over the leverage, what do you guys kind of view as the right point for leverage, with the SBIC debt and without?

That's a great question, Greg. As you all know, we mentioned we have two SBIC licenses, those have exemptive relief from the SEC. So on those particular boxes under PNNT, we can leverage $1 of equity to $2 of debt. So that's always a possibility. It's also we view that as cushion. We still view it as, on an overall basis including the SBIC debt, we want to be levered 0.6 to 0.8 times debt-to-equity. We always have the extra cushion there for both defensive purposes as well as offensive purposes, but we're still focused on the 0.6 to 0.8 times debt-to-equity ratio on an overall basis including the SBIC.

Great, that's all for me. Thanks guys.

We'll hear next from Greg Mason with KBW Brokers.

I wanted to talk about, you had a significant number of refinancings this quarter. However, the fee income really didn't show an uptick, in fact it was down from last quarter. Is there some reason the high activity this quarter didn't generate more fee income?

Sure. I mean that's a great question. It really just depends on if there's still a prepayment penalty left to be paid during the quarter. So for instance, on Last Mile Funding we did get a 2% prepayment fee and on Galls we got a 3% prepayment fee, but on some prepayments that we had, for instance Jacuzzi, Performance Inc., et cetera, we did not get a prepayment fee. So it just depends, like Jacuzzi and Performance have been investments we've had for a long period of time and that prepayment penalty are already burned off by the time we got repaid. So that is just kind of idiosyncratic with the particular deal. The two deals that are publicly announced in terms of refi this quarter, Brand Energy will have a prepayment penalty and we have this investment in Affinity called Good Sam, it's an Affinity club for RVs, and we're going to get tendered at about [1.09%] (ph). So those are the two that are publicly known that will be refied for this quarter.

Great, and then on those lines, I think there's been some information about Penton Media and Jacobs Entertainment have been involved in new financing transactions in the fourth quarter. Do those new transactions impact the securities you hold at all?

That's a good question. Penton was a refi. We did take a look at the new deal and you'll know in February whether we participated in it. And Jacobs, there was nothing that significantly impacted our piece of paper which continues to perform well. You might be thinking about another Jacobs, you might be thinking about Jacobson, not Jacobs Entertainment.

Apologies. And then with the Affinion, I think there are a couple of options for that investment, I know it's an exchange into a higher yielding picked piece or I think there's some other notes higher in the capital structure that you could move into. Could you just talk about the options you have with Affinion and if you are leaning one way or the other on that investment?

It's a great question. So just to put everybody on the same page, we as of September 30 and still today own Affinion 11.625% bonds. There is an exchange offer in the market to exchange those securities into a 14.5% piece of paper with 15% warrants. That 14.5%, as Greg you said, is picked. So those are liquid instruments. So kind of step number one is, exchanging our existing paper instrument to new paper. As a result of this exchange, Affinion 11.625% have traded from $0.57 on the dollar to the mid-80s. We are evaluating the exchange, certainly I think we are going to participate in the exchange, and since it is a liquid instrument, we always have options, do you buy more, do you sell, there's a piece of paper higher in the capital structure that's a 13.5% cash pay instrument that we're evaluating as another opportunity. We know the credit well, we think the future can be really interesting for this company as they expand their loyalty and international segments. We think this warrant that we're getting to be really interesting. So we're evaluating all of our options and you'll know in February what we've actually done, if anything.

Great, and then one last question. I see on the balance sheet, you've got a $52 million payable for investment purchase. I assume those are deals that closed right at the very end of the quarter. Is that correct and so essentially you don't have any income this quarter from those investments?

That's right. Those are deals where we've committed by quarter end and they usually close within a week or two of the end of the quarter. So they are booked as investments even though they haven't closed.

Okay, great. Thank you, guys.

We'll take our next question from Doug Mewhirter from SunTrust Robinson Humphrey.

Most of my questions have been answered. I wanted to talk a little bit about your yields. It seems like over this past say four quarters, the yields have been coming down across most of the middle-market, but it seems like there's been a bit of a stabilization. You're only down by 10 basis points sequentially on your stated deals. And also I noticed on your new investments, despite going a bit higher in the capital structure, year-over-year your new investment yields are about 20 basis points higher. Is that an anomaly, do you think that there is some stabilization in yields and in where you're playing right now?

It's a great question. Look, as you know, Doug, we don't come into the office everyday and say, we have to grow. We have a risk-reward bucket that we want to fill with good risk-rewards. So generally that means rational debt-to-EBITDA multiples, generally that means rational yields. If we can find investments that fit that bucket, we'll certainly look to do them, and if not, we won't. The market continues to kind of – yields continue to kind of go down a little bit. That said, in this quarter ended 12/31, we're finding some interesting stuff that's more traditional middle-market M&A or growth financings that certainly is well within the zone of what we've been doing from a debt-to-EBITDA multiple and yield multiple. So hard for me to make any kind of overall market commentary, but for us and kind of our slow growth mentality, we're finding enough for now to do that's interesting.

And actually that just triggered a follow-up question on that. Do you think though that maybe some of the underlying terms and conditions have deteriorated, so even if a like-for-like yield, there might be a little less underlying protection in terms of covenants or maybe the pick versus cash share?

Yes, more what you're worried about is debt-to-EBITDA levels going up and yields coming down, and for us, more so leverage levels might get unreasonable. So we will not do deals that we're not comfortable with from the standpoint of a debt-to-EBITDA multiple. So certainly multiples have pushed up a little bit and we let plenty of deals go with people we've got really good relationships with, and we like the companies but we just don't like the risk-reward. So that's okay, we're okay on it in the slow growth environment right now picking our spots.

Okay, thanks for your answers. That's all my questions.

We'll take our next question from Chris York with JMP Securities.

Most of my questions have been answered, but I wanted to get a little bit more color on the decline in the underlining leverage at your portfolio companies to 4.5 times. Is that due more to the new investments put on the balance sheet or is that more towards the exit of investments?

So our new investments came in this quarter at about 4.6 times. So it's really mostly existing credits deleveraging. Now that's what you hope happens, you won't be a lender company at whatever 4.5, 5 times and over time it deleverages. So that is kind of what's going on broadly in the portfolio,

Got it. Alright, that's it for me. Thanks.

We'll take our next question from John Hecht with Stephens.

Just a couple, and the first one is more kind of strategic. Over the past year, you've taken your adjustable-rate composition up quite a bit from where it was before. It seemed to me that was in the context of waiting for rising rates. But this quarter, it looks like you're getting more second-lien fixed rate stuff. Are you kind of at a point where you feel good about the composition, how should we think about where you're focused in the next three or four quarters?

That's a great question, John. Look, all things equal, we prefer floating rate, right, with a floor that gives us maximum optionality. If this economic recovery continues, it gives us maximum optionality and the upside of when we can negotiate it or get it. If we do fixed rate, we prefer very high fixed coupon such that as the company deleverages, they have the right incentives to pay us back. But we think we are very well kind of aligned if you look at our debt and what's going-on on the liability side of our balance sheet. We've got our bond, our 12-year bond, and we've got SBIC license 1 which is $150 million locked at about 4%. We've got another $75 million, hopefully that will be locking here over the coming quarters. So we like in general having locked liabilities and having assets that can float up. So we kind of like where we're positioned, but it's always tough to bet on interest rates. For us, it's mostly about betting on credit. That's why we think people invest with us, as we think we're pretty good at credit, but we do want to be as smart as we can around liability and asset matching/mismatching, et cetera, and in this case we'd like as much liability to be fixed as possible as well as assets to be floating. Our liabilities, we do have this credit facility that's L plus 275 that we did a couple of years ago. That's a little bit above market right now and that may be an opportunity for us to reduce the cost of our liabilities over time.

Okay, that's good color. Thanks. Second question is do either repayments in the quarter, was there any OID in the interest of that?

Sure, I mean in terms of when a company gets paid off, an OID has been amortising up to par, is that your question, John?

Yes. I guess was there any incremental OID in the interest income line this quarter?

No, I mean you did see for instance we bought some Instant Web at a discount in the secondary market at about $0.75 on the dollar. That company is now levered under 5 times. It's doing well. That piece of paper is now quoted in the mid-90s. So it was a nice add-on secondary opportunity for us. But if we buy it at $0.75 for instance, if we think we will get paid out at par, which we do in this case, we will accrete that discount to par at maturity.

Okay, so just at maturity. Okay, and then you had about $101 million of investments in existing companies. Was that all refi or was there any other kind of catalysts that drove some of those investments in the quarter? Just trying to characterize kind of what's going on in the investment environment right now.

Yes, sure. So Pre-Paid Legal or [indiscernible] was a big one, that was a refi. As an equity co-investor here and as a participant in a dividend, more room in that company to own, we are happy for its cost to be lower, really like the credit is levered under 4 times, it's spuing cash flow. So that was a refi. K2 was a refi. Company is doing well. Instant Web as I said was more of an add-on secondary market purchase at a nice discount. So those were the three kind of existing names. And we did a small add-on for Service Champ, a small add-on subordinated debt instrument, $4 million. That company continues to do add-on bolt-on acquisitions in this industry.

Okay, so some refi and some just growth capital, is that fair to characterize it that way?

Yes, and we would say K2 is growth capital, Service Champ is growth, Pre-Paid Legal and Instant Web are – Instant Web is secondary and Pre-Paid Legal is a refi.

Okay. And then last question, Affinion, I know it traded down last quarter and that was the concern around the government shutdown. It seems like it has traded back up nicely. Was there any real growth in the performance of that or was it fairly stable the whole time?

The company has been impacted historically by the CFPB, the Consumer Financial Protection Bureau, since a bunch of its clients are U.S. financial institutions. They are finding other growth avenues in other segments such as loyalty and international, which is really the growth plan going forward which we think makes it a really interesting opportunity as they kind of grow out and away from the CFPB risk.

Okay, so they've been experiencing EBITDA expansion now?

Yes.

Okay, perfect. Thanks very much.

We'll take our next question from Douglas Harter with Credit Suisse.

You had mentioned that you were hoping to lock the next $75 million of the SBA soon. I guess what are your plans for being able to deploy that and how does that market look for [indiscernible]?

That's a great question. Certainly some of the activity that we're doing this quarter, the quarter ended 12/31, looks like it fits the SBIC eligible – it's an idiosyncratic thing whether the deals we do fit the definition of a small business under the SBA guidelines. Looks like this quarter we will have some that do fit. We're optimistic, obviously if something fits, it's going to certainly go into the SBICs because we would like to fill up those buckets and lock those rates, but we're not forcing it. To us, the most important thing is credit quality.

Great. Thanks Art.

We'll take our next question from Arren Cyganovich with Evercore.

I guess I'm just a little bit surprised that you're finding more attractive opportunities, more M&A like opportunities in the December quarter given the overall environment. How are you coming across these? Are these sponsored driven deals or are they other kind of direct investments that you're finding?

It's a great question. It's a mixture of sponsor related and direct. The sponsored deals are with sponsors that we've had a long, long term relationship with where we've built trust over time, so where we get a first call and we get a last look. And so there are going to be sponsors that we've done other deals for where we've developed a trusted relationship, and that's a big part of our business model on the origination side. If we walk into a room and there's ten of our friendly competitors there, we know that we're adding a lot of less value, and if we walk into a room and there's one or two of our friendly competitors – we don't think we have sponsors for having other people in the room because frankly, we may say no, because we say no most of the time. So it's fair for them to have other folks in the room. It's a question of when we like something, do we get a fair shot at the business. So a few of these deals are middle-market sponsor, secondly they're mezz based on relationships with credits that we like and where leverage levels are reasonable. Some of them are – we have a non-sponsor dealer too where we have a particular view of an industry or have a special relationship with the management team and we think we're getting a really interesting risk-reward, where we're getting a really nice yield and where our debt-to-EBITDA levels are reasonable.

So the non-sponsored deals are management deals that you've generally just worked with in the past or how does this usually come about?

They are in industries that we've evaluated in the past or we've linked into a management team or with diligence enough and the structure of the deal is we think safe and compensates for the fact that there is not a sponsor.

We'll take our next question from Casey Alexander from Gilford Securities.

My question was answered. Thanks.

At this time, I'm showing no further questions. I'd like to turn the call over to Art Penn for closing remarks.

I'd like to thank everybody to be on the call today. We're filing our next Q in early February, so we'll be speaking to you then. Have a great holiday season and New Year. Talk to you in February.

This does conclude today's conference. We thank you for your participation. You may now disconnect.