PennantPark Investment Corporation (PNNT) Q2 2016 Earnings Report, Transcript and Summary

Good morning, and welcome to the PennantPark Investment Corporation's Second Fiscal Quarter 2016 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 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 second fiscal quarter 2016 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 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 as well as on our website. I'd like also 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 provide an update on the business starting with financial highlights, a discussion of our energy portfolio, followed by a discussion of the overall market, the overall portfolio, investment activity, the financials and then open it up for Q&A. For the quarter ended March 31, 2016, we invested $86 million at an average yield of 10.8%. Expected IRRs generally range from 12% to 17%. Net investment income was $0.29 per share. Given the continued headwinds and volatility, we continue to focus on our energy portfolio which includes those companies and our schedule of investments listed as oil and gas and energy and utilities. Our focus is on companies that have strong management teams, attractive asset portfolios, and the ability and time to endure the current market conditions. The investments we control or have the ability to influence strategy will be our primary focus. In these situations we intend to work with our portfolio companies to ensure that they have the resources, personnel, capital, and runway to maximize our long-term recovery to weather this tumultuous period. As of March 31, 2016, our energy portfolio had a cost of $212 million and was marked at $114 million on a market value basis which is $0.54 on the dollar. This represents 15% of the cost and 9% of the market value of our overall portfolio respectively. Valuations on our energy investments fell by $10 million from the quarter ended December 31, 2015, representing $0.14 per average share. As we have mentioned previously, independent third-party valuation firms value all of our non-actively quoted investments. Many have asked us what happens to NAV and NII if our energy investments are completely written off. While we do not think all of our energy investments are worthless and believe that they are fairly valued, as of March 31 NAV would have been at $7.23 per share if all of the energy investments were written off. If all of the energy investments were put on nonaccrual, NII would decrease by less than $0.03 per share per quarter. As shareholders and managers we are disappointed with the performance of our energy portfolio and intend to work diligently to recover our capital on our energy investments and to grow our NII back to historical levels. While we do not believe that the short run option of selling these assets at fire sale prices is prudent, that said we monitor each situation and investment on a case by case basis and in this challenging environment for oil prices, we intend on taking an approach that will maximize value in the long run. For the quarter ended March 31 we waived base and incentive fees which equaled the percentage of the cost value of our energy portfolio, 16% as of December 31, 2015. This waiver amounted to $1.7 million, representing $0.02 per share. This waiver will continue until December 31, 2016. We believe that this waiver demonstrates a strong commitment to our shareholders and our focus on our energy portfolio. In addition to this fee waiver, two other positive factors are helping to offset the energy issues. First, Z Wireless, aka Diversified, was sold and we realized a capital gain of $3.4 million or $0.05 per share and prepayment fees of $5.5 million or $0.08 per share of other income. Other income is a category that we have in our income statement to represent prepayment fees or waiver and amendment fees that are not part of ongoing interest income. Other income has averaged $0.04 per share per quarter over the last couple years. In December, SBIC legislation was passed which raised the amount of available borrowings to $350 million which will enable us to continue to use this program and create value for our shareholders. We are finding attractive investments for SBIC and believe that our SBIC licenses will enable us to avail ourselves of that capital. During the quarter we borrowing $22.5 million in SBIC II and have continued to borrow since quarter end. The $22.5 million piece of SBIC II was fixed for ten years at an extremely attractive all-in rate of 3.2%. We look forward to fully utilizing the upside $150 million of borrowing capacity in SBIC II and utilizing an additional $50 million of borrowing capacity in a potential SBIC III. With regards to our dividend, our board regularly evaluates the earning power of the company relative to the dividend. Our substantial spillover cushion which was $0.53 per share as of September 30, the fee waiver through December 31, 2015, substantial other income from prepayment fees, and SBIC usage give us the flexibility to continue to evaluate our portfolio and the market without rushing to make a decision on any change to the dividend at this point. With regards to the market, the economic signals are mixed and company performance varies by industry. With regards to the more liquid capital markets and in particular the leveraged loan and high yield markets, during the quarter ended March 31, those markets experienced volatility as high yield and leveraged loan funds experienced outflows due to expectations of Fed tightening, turmoil in the energy market and a weakening Chinese economy. This impacted the tone of the middle market and generally resulted in a better opportunity to invest in attractive risk reward. Recently the market has stabilized and remains attractive. As debt investors and lenders, a flat economy is fine as long as we run our capital structures prudently. A healthy current coupon with deleveraging from free cash flow over time is a favorable outcome for us. We remain focused on long-term value and making investments that will perform well over several years and can withstand different business cycles. Our focus continues to be on companies and structures that are more defensive, have low leverage, and strong covenants and high returns. 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 long term trust. Our focus is on building long-term trust with our portfolio companies, management teams, financial sponsors, intermediaries, our credit providers, 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 conflicts or affiliations, we've become a trusted financing partners for our clients. Since inception, PennantPark entities have financed companies backed by over 150 different financial sponsors. We completed our stock buyback program. Last quarter we purchased about 700,000 shares for about $3.7 million, bringing our total program to 4 million shares for approximately $30 million. Our portfolio is constructed to withstand market and economic volatility. In general our non-energy portfolio is performing well despite a mixed domestic and global economy. We have a cash interest coverage ratio of 2.4 times and a debt to EBITDA ratio of 4.9 times at cost on our cash flow loans. Additionally over the last 12 months the percentage of portfolio that's in first lien secured assets has increased from 28% to 37%, reducing the risk of the underlying portfolio. We are pleased that we have diversified funding sources with several features that reduce overall risk to the company. First, we have $321 million in long-term unsecured bonds and have only utilized about 25% of our long-term $545 million credit facility. Second, as we discussed, we're utilizing the expanded capacity under the new SBIC legislation. SBIC financing creates a financial cushion and we have exemptive relief from the SEC to exclude SBIC debt from our BBCS coverage desk and SBIC accounting is cost accounting, not mark to market accounting. Third, to better align measurement of asset and liability values for both GAAP and the BDCS coverage test, we mark both our assets and liabilities to market. As a result of all these features we have provided substantial safety to our shareholders, bond holders, and lenders in the event of market volatility. We've had some attractive realizations. In addition to Z Wireless, last quarter Veritext was sold, resulting in our $4 million equity co invest getting realized at approximately $8 million which is a 13% IRR. Last quarter we placed Bennu oil and gas on nonaccrual. The company has entered into a forbearance agreement with its lenders. Bennu is working on a strategy to navigate the current industry downturn while preserving the ability and runway to develop an attractive proven well, a PUD that has high potential. Also last quarter we sold our position in Linc Energy and realized the loss. We decided that this was the best way to maximize value given our ability to impact the ultimate outcome and our focus on allocating capital to those names where we can influence or control strategy or the business plan. With regards to Ram Energy, there's no material operating change since last quarter. The company continues to operate in order to preserve value and flexibility over time. The CEO, Larry Lee, is a long-time industry veteran. Our strategy in the future may include strategic acquisitions, divestitures, or mergers. On New Gulf, the confirmation hearing occurred on April 20 and the reorganization plan was approved by the court. The company is expected to emerge from bankruptcy in the coming days. Our first lien convertible note balance will be $24.1 million and our total equity ownership, conversion of the convertible notes, will be approximately 16%. We will take an active role in the ownership of the company. Across PennantPark entities we've had only 13 companies on nonaccrual out of nearly 400 investments since inception 9 years ago despite the recession during that timeframe. Further, we are proud that even when we had those nonaccruals we've been able to preserve capital for our shareholders through hard work, patience, and judicious additional investments in capital and personnel in those companies, we've been able to find ways to add value. We constantly monitor our deals and underwrite them in the face of new information. In situations where the best long-term value for shareholders is created by taking control of the companies and providing capital and expertise, we do. Based on values as of March 31, today we've recovered nearly 75% of capital invested in those 13 companies that have been on nonaccrual since inception of the firm. We are proud of our long-term track record, over nine years including the recession. Since inception, PNNT has made 180 investments totally $3.8 billion and an average yield of 12.5%. Including both realized and unrealized losses, PNNT has lost only 56 basis points annually including both unrealized and realized losses. In terms of new investments, we had another quarter investing in attractive risk adjusted returns. In 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 a couple of the highlights. We purchased $44 million first lien term loan to LSF9 Atlantis, also known as A to Z Wireless. A to Z is a Verizon wireless premium realtor. Lone Star is the sponsor. VT Buyer is a national provider of deposition and litigation support services to law firms, corporations, and regulatory agencies. We won $21 million of second lien term loan. Pamplona Capital is the sponsor. Turning to the outlook, we believe that the remainder of 2016 will continue to be active due to growth in M&A driven financings. Due to our strong sourcing network and client relationships, we're seeing active deal flow. Let me now turn the call over to Aviv our CFO, to take us through the financial results.

Thank you, Art. For the quarter ended March 31, 2016 recurring net investment income totaled $0.21 per share. In addition, we had $0.06 per share of other income net of incentive fees and $0.02 per share from the fee waiver. As a result net investment income for the quarter was $0.29 per share. Looking at some of the expense categories, management fees after waiver totaled $9.1 million, general and administrative expenses totaled $1.8 million, and interest expense totaled $6.9 million. During the quarter ended March 31, unrealized loss from investment was $60 million or $0.22 per share. Unrealized gains from our various debt instruments was $10 million or $0.14 per share. Realized losses from investments was $11 million or $0.15 per share. The accretive effect of our share buyback was $0.03 per share and excess net income over dividend was $1 million or $0.01 per share. Consequently, NAV per share went down $0.19 from $9.02 to $8.83 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 effective price provided by independent valuation firms, securities and exchanges, or independent broker-dealer quotations when active markets are available under ASC820 and 825. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value the investment. Our overall debt portfolio has a weighted average yield of 11.9%. On March 31 our portfolio consisted of 61 companies across 28 different industries. The portfolio was invested in 37% in senior secured debt, up from 28% a year ago, 39% in second lien secured debt, 14% in subordinated debt, and 10% in preferred and common equity. 76% of the portfolio has a floating rate, including 72% with a floor. And the average LIBOR floor is 1.2%. 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 consistent dividend stream coupled with long-term 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 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 continued investment and confidence in us. That concludes our remarks. At this time I'd like to open up the call to questions.

Thank you. [Operator Instructions] And our first question will come from Doug Mewhirter with SunTrust.

Two questions. First, while some of your mark downs this quarter have been due to company-specific issues, especially in the energy portfolio, but I assume some of it was also technically related, just general market spreads. Do you anticipate any kind of recovery? I know the market spreads have tightened in the second quarter to date. Would you anticipate any possible accretion in your marks again if the market holds in the second quarter?

Sure. Thanks, Doug. One would anticipate that spread tightening would help the portfolio as well as oil prices are up quite substantially since quarter end. So, no guarantees. It's still a long ways between now and June 30 but since quarter end there's been a general uptick in the market in both oil prices and the leverage line in high yield indices.

Thanks. My second question on your pipeline, it looks like you're going to take advantage of the extra leverage afforded by the SBIC program. I know that investments have to fit a specific criteria that they're generally a little smaller, they're restricted by industry and I guess two questions on that. Is the relative attractiveness relative to your -- maybe a conventional sponsor deal for a SBIC eligible deal right now in terms of terms or yields or whatever? And also is your phone ringing just as much from these SBIC companies or do you have to maybe work a little harder to find those deals? Or is it actually good in terms of deal flow?

That's a great question and it's something we grapple with. First and foremost we have to keep our credit standards high and the same as they are whether they fit in the SBIC or not. They have to be our kind of deal. They have to hit our metrics and we have to be comfortable with however it gets financed, whether it gets financed through the SBIC, the credit facility, or our bonds, et cetera. So, that said there are and it is kind of arcane what fits and what does not fit. But as an example, the VT Buyer deal we did during this past quarter is a sponsored deal and it does fit the SBIC. So, that was a nice situation. We've done a deal since quarter end. It's a sponsor deal that we like and it fits our parameters, and it does fit the SBIC. So, we're out there. Look, we're looking a little harder earlier on to see if something fits and hits our credit parameters because it is such advantageous financing, 3% for ten year money. So, we're looking hard. We don't want to drop any of our standards from a credit standpoint.

Okay. Thanks, that's all my questions.

Okay. Next we'll move to a question from Arren Cyganovich with DA Davidson.

With respect to the New Gulf restructuring, can you talk about how that's going to look on your balance sheet? I know you said you're going to convert into equity. Are you going to have any remaining income paying piece from that after its done? Or is it going to go straight into equity? And then will there be realizations of loss on that restructuring?

Yeah. So, what we will own is about $24 million of a first lien convertible note that is in note form initially. There's no other debt on the balance sheet. And that will at least day one not be converted into equity. So, it will be a first lien convertible note. We're still working with the accounts whether there's from a tax standpoint a realized loss or not. We don't know for sure yet. We'll know after the transaction happens.

So, from the $24 million of first lien note, I think that's also marked up slightly from where you had it at the end of the quarter but the $24 million, that actually will be paying you some form of interest that will be additive to your NII?

If it pays cash it's 10%. If it pays PIC it roughly 12%. The markup is due to some warrants that we got and fees that we got as a backstop provider through the bankruptcy.

Got it. Thank you. And just in terms of your comments on seeing inactive deal flow, it's a little bit at odds with some of the other middle market folks that we've talked to thus far this quarter, hearing that it's still relatively slow out there, even though it has picked up a little bit from the beginning of the year. I guess what's the difference there from what you're seeing? You're getting the same level of inbound inquiries, et cetera, in terms of activity you can invest in?

That's a good question. We're seeing a lot of activity. As you know, Arren, activity is one thing and deals closing is another. We are getting pinged quite a bit. What closes, I think some of the indigestion in the market has been with a weird environment out there -- that's my technical term for it -- it's sometimes tough for buyers and sellers to agree on price. So, we're getting pinged quite a bit. We're hopeful that those deals do come to fruition. Some deals have hit some indigestion because in this interesting environment we have out there, there's in many cases a de-linkage at the end of the day between buyers and sellers as to where they can transact.

And next we'll move to a question from Jonathan Bock with Wells Fargo Securities.

Joe Mazzoli filling in for Jonathan Bock. Thank you for taking my questions. Just very quickly you mentioned the ability to influence outcomes is important and this contributed to the sale of Linc. But I'm just curious, when thinking about Bennu, how does this ability to influence the outcome come into play? Because this was -- I think it was a Deutsche Bank led deal -- excuse me, CS led deal. And there's likely many lenders in the syndicate. So, how do you think about influencing the outcome?

It's a great question and there's a variety of factors. Certainly being able to influence the outcome on Bennu, we are not a big player. The difference is we are more optimistic about the outcome and our ability to recover substantial capital on that one given the PUD that they have that as high potential.

Fair enough. That makes sense. Just one more from me is, on Linc, I believe this was not on nonaccrual as of last quarter. So, this was still accruing interest with a fair value mark of 25 as of 12-31. So, when assessing to sell, to kind of exit, reduce the energy exposure or to kind of hold on and continue collecting the income, how do you think about this? Or is this kind of an imminent nonaccrual with maybe likely a little in the way recovery? Is that -- am I think about that in the right way?

Yeah, you're thinking about it the right way. After our earnings last quarter they announced their earnings. Based on that information, based on what we were hearing, we believed that was going -- that was not going to be a good outcome based on the fact that we were on the periphery and we did not have a major seat at the table and where we were going to allocate capital to our energy portfolio, we decided to realize the loss unfortunately and use that capital towards other situations in the portfolio where we did have a major seat at the table or we were more optimistic about the outcome.

Okay. That's great. Thank you, guys, for taking my questions.

And we'll now hear from Ryan Lynch with KBW.

Just one more on Linc. I was looking at the last quarter mark. It looks like you guys had one piece marked at about $0.25 on the dollar, another piece at $0.83 on the dollar. When you guys sold those investments off, what were roughly the exit prices of those?

You saw realized loss this quarter and the vast majority of that was due to Linc. So, unfortunately, again after we had our earnings last quarter and after last quarter they announced their numbers. They were not good. We assessed the information and our ability to impact it, how we were going to allocate our capital and we thought the better part of valor in that particular case was to realize the loss, get whatever capital we could out of it, and reallocate that capital to where we thought we had a better chance of recovery. So, it's disappointing and embarrassing but that happens in our business unfortunately every once in a while.

Sure. And you guys have chosen to waive fees surrounding your oil and gas exposure. That's a very shareholder friendly benefit that you guys have voluntarily done. And I really appreciate that but obviously that's only temporary and that will run off. So, what are your thoughts about potentially expanding those waivers beyond 2016 or just changing the fee structure now that you've been operating with those lower fees for a couple of quarters, maybe changing the fee structure to something lower, maybe a little more in line with some of the recently IPOed BDCs?

Sure. That's something our board will take up at the appropriate time, towards the end of the year. Clearly if energy is still in the doldrums at that point in time we would anticipate continuing the waiver and the board is of course always looking at everything and will continue to assess the fees and the costs. We do want to point out that up until the energy downturn we had realized gains for over nine years, through the recession, and a very strong track record. We're certainly very disappointed with ourselves and are taking, sharing, and taking a lot of pain as shareholders and as management. Which is why we don't want to earn a dime on our energy portfolio at this point in time and the board will assess the situation in a few quarters and make a decision at that point in time.

We’ll now move to a question from Mickey Schleien with Ladenburg.

Most of my questions have been asked but I wanted to get a clarification. Art, have you actually started an application for the third SBIC license?

That's a good question, Mickey. We would start that application as we've utilized fully SBIC II. So, we're still working our way through the rest of SBIC II. As we come to the end of SBIC II, we'll start application for SBIC III.

At the pace that you're going that sounds like that might be this year. Would you agree with that?

It's a hard question to answer. It's always hard for us to give quote-unquote origination guidance to people. We hope so. Our goal is to find deals that fit our credit parameters and fit the SBIC here. So, that would be our goal but certainly there's never any guarantees.

I appreciate it. Thanks for your time.

Now we'll hear from Christopher Nolan with FBR and Company.

Aviv, recurring income this quarter was $0.21. As I recall last quarter it was $0.23. What was the driver of the difference?

So, the recurring income, the way we look at it is really kind of it's about $0.22. That's the way we should look at it. One quarter might be a little bit higher or lower but $0.22 is really kind of the -- what's effecting based on Linc activity and Bennu activity that was happening last quarter. So, it will ebb and flow by $0.01 or so but that's kind of as it goes, $0.22.

Okay. And the driver of $10 million in depreciation and debt carrying values, is that related to credit rating agencies putting the company on a negative outlook?

That's the mark to market on all of our debt instruments as we said in our prepared remarks. We do mark our liabilities to market. Some of the liabilities do trade. The bonds trade in the NYSE, the institutional bonds trade in the marketplace. Our credit facility gets valued by the independent third-party valuation firm.

Okay. [Operator Instructions] Next we'll move to a question from Chris York with JMP securities.

My question here is just a follow up to Mickey's question and then maybe, Art, your prepared comments about the potential pursuit of the third SBIC license. We would think the SBA doesn't want to be a lender of last resort to PDCs with the capital markets difficult to access, especially for those trading below book value. So, could you give us an update on any conversations you have had with the SBA about potential pursuit of this third license?

Thanks, Chris. Great question. The SBA's had a fantastic experience with us. There's not been one dime of loss in the SBIC portfolios that we've run for them. So, hopefully they would not view themselves as being a lender of last resort to us. We've had a great relationship with them and I would think our track record with them having been perfect so far would not be viewed as a lender of last resort.

And we'll move to a question from Bryce Rowe with Robert W. Baird

Just wanted to maybe follow up on that same SBIC, SBA theme. Art, I was curious, I guess in the past you guys have talked about an additional $75 million of capacity within SBIC II and so with the past legislation, have you in fact gotten an additional $75 million of commitment from the SBA at this point?

Certainly. Yes. We do have $150 million on SBIC II commitment and obviously we're working towards fully utilizing that. So, that $75 million old commitment is now $150 million commitment.

Okay. And next we'll hear from Kyle Joseph with Jefferies.

Thanks for taking my questions. I was just hoping to get a little more color on your outlook for the portfolio yield overall and sort of what terms you're seeing on new deals in the middle market?

Yes. Good question. I think what we've seen in the last quarters is kind of where we are. We're blending a little bit, a mixture of first lien unit tranche, some second lien, and we have about an 11% yield. I think that's kind of where we are now given that we're skewing a little bit more senior than we have in the past at this point. But it's always deal by deal, credit underwriting, that we're focused on.

No further questions in queue at this time, sir.

Great. I'd like to thank everybody for their time and focus this morning and we look forward to speaking to you next quarter.