PennantPark Investment Corporation (PNNT) Q2 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the PennantPark Investment Corporation's Second Fiscal Quarter 2019 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 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 now begin your conference.

Thank you and good morning everyone. I'd like to welcome you to PennantPark Investment Corporation's second fiscal quarter 2019 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 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 the 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.

Thanks, Aviv. I'm going to provide an update on the business starting with financial highlights followed by the discussion of the overall the market, the portfolio, investment activity, the financials and then open it up for Q&A. For the quarter ended March 31, 2019, we invested in $184 million and primarily first lien secure debt at an average yield of 9.1%. Coordinate investment income was $0.19 per share. We are pleased that our current run rate net investment income covers our dividends. We purchased $7 million of a common stock this quarter as part of our stock repurchase program, which was authorized by our board. We've completed our program and have purchased $29.5 million of stock. The stock buyback program is accretive to both NAV and income per share. As of September 30, we had taxable spillover of $0.30 per share, which provides further dividend cushion. With the generally stable underlying and substantial spill ever, we believe that PNNT stocks should be able to provide investors with an attractive dividend stream along with potential upside. As you all know, the small business credit availability after it was signed into law in late March, 2018, in February, 2019 our shareholders approved the reduction of the asset coverage test from 200% to 250%. In connection with this reduction, we reduced our base fee from 1.5% to 1% on gross assets that exceed 200% of PNNT's NAV at the beginning of each quarter. Over time, we were targeting a regulatory debt to equity ratio of 1.1 to 1.5 times. We will not reach this target overnight. We will continue to carefully invest and it may take us several quarters to reach the new target. We prepaid $250 million of our notes. In connection with that we closed on a new $250 million credit facility with BNP to complement our existing $445 million credit facility and our $150 million SBIC2 financing. Our primary business of financing middle market sponsors has remained robust. We've managed relationships with about 400 private equity sponsors across the country from our offices in New York, Los Angeles, Chicago, Houston in London and we've done business with about 180 sponsors. Due to the wide funnel of deal flow that we receive relative to the size of our vehicles, we can be extremely selective with our investments. In this environment, we have not only been extremely selective but we have generally moved ups capital structure to more secure investments. A reminder about our long-term track record, PNNT was in business in 2007 then as now focused on financing middle market financial sponsors. Our performance through the global financial crisis and recession was solid. Prior to the onset of the global financial crisis in September, 2008, we initiated investments which ultimately aggregated 480 million. Average EBITDA of the underlying portfolio companies was down about 7% to the bottom of the recession. According to the Bloomberg North American High Yield Index, the average high yield company EBITDA was down about 40% during that same timeframe. As a result, we had few defaults and attracted recoveries on the portfolio. The IRR of those underlying investments was 8% even though they were done prior to the global financial crisis and recession. We are proud of this downside case track record. We've had only 13 companies going non-accrual out of 223 investments since inception 12 years ago. Further, we are proud that even when we've had those non-accruals, we've been able to preserve capital for our shareholders. It's been two and a half years since we've had had a non-accrual at PNNT and that run had to end at some point. As of March 31, 2019 we had one non-accrual which represents 1.4% of our overall portfolio of cost and market value. Since inception, PNNT has made 223 investments totaling about $5.3 billion out of the average yield of about 12.2%. This compares to an annualized loss ratio including both realized and unrealized losses of about 32 basis points annually. This strong track record includes both our energy investments as well as our primarily subordinated debt investments made prior to the financial crisis. At this point in time, our underlying portfolio indicates a strong U.S. economy and no signs of a recession. We remain focused on long-term value and making investments that will perform well over an extended period of time and can withstand different business cycles. We are first call for middle market financial sponsors, management teams and intermediaries who want consistent and credible capital. As an independent provider of free of conflicts affiliations, we are a trusted financial partner for our clients. In general, our overall portfolio's performing well. We have cash interest coverage ratio of 2.7 times and a debt EBITDA ratio of 5.2 times that cost on a cash flow loans. With regard to our energy-related portfolio, we are pleased that we've made progress monetizing some of those investments at reasonable values over the last year. We are also pleased to see higher energy prices over the last few months which resulted in increases in the fair market value or our energy investments in this past quarter. RAM is focusing on it's Austin Chalk position in eastern Texas. The company commenced the limited drilling program. Their early results have been strong on an absolute basis and relative to other operators in the area. We are encouraged by their early performance. RAM plans to solely focus on the development of the Austin Chalk assets and monetize all of their assets over time. The positive fair market value increases of our energy portfolio this past quarter was more than offset by valuation declines in other assets as we move towards the exit of investments that are largely equity positions. As a result, our overall NAV was down for the quarter. As of March 31, Park holdings was our largest debt investment. We are pleased at the recapitalization and exit of that investment closed yesterday. It was a complex situation and we are thankful of the efforts of everyone to make the deal happen, including the existing ownership, new investors, government agencies, and regulators who all worked tirelessly to make it happen. We received our interest and principal at about 98% of original cost. This resulted in a realized IRR of 13.8% and a multiple on invested capital of about 1.6 times. We're thrilled with the realized returns of this investment and we're looking forward to using these proceeds to further our strategic direction of a more diversified portfolio with more modest bite sizes, which are higher in the capital stack. In terms of new investments, we've known these particular companies for a while that studied the industries or have a strong relationship with the sponsor. Let's walk through some of the highlights. We purchased $1.2 million of revolver and $17.6 million of a first lien term loan of HW Holdco, Hanley Wood. The company is a business to business data marketing immediate company primarily serving the residential construction market. MidOcean Partners is the sponsor. We purchased $15.4 million of the first lien term loan and funded $900,000 of the revolver of lumbar brothers, the company is a manufacturer and distributor of ophthalmology equipment. Atlantic Street is the sponsor. We funded $100,000 a revolver and $9.9 million of first lien term loan of per for software. The company is a provider of version control project management and cogent testing software. Clearly, Capitol is the sponsor. We purchased $41.5 million of the first lien term loan and funded $300,000 a revolver of TVC enterprises. We also purchased $1 million of common equity. The company provides membership-based legal services to commercial truck drivers. Gauge Capital's sponsor. Turning to the outlook, we believe that the remaining part of 2019 we'll be active due to growth and M&A driven financings. Due to our strong sourcing network and client relationships, we're 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, 2019 core net investment income total $0.19 per share including $0.01 per share of other income. We also had $0.07 per share of one-time financing costs relating to our new BNP facility and they may call all of the payoff of our notes. Alternating the incentive fees of $0.04 per share, the net effect of these one-time financing costs was $0.03 per share. Our GAAP NII was therefore, $0.16 per share. Looking at some of the expense categories, management fees totaled $4.5 million. General and administration expenses total of $1.2 million, one-time financing expenses totaled $4.9 million and interest expense totaled $7 million. During the quarter ended March 31 unrealized loss from investment was $20 million or $0.30 per share. Unrealized gain on our investments was $3.7 million or $0.06 per share. We had about $1 million or $0.01 per share on realized gains. The accretive effect of our share buyback was $0.03 per share. Our dividend exceeded our GAAP net investment income by $0.02 per share. Consequently, NAV went from $9.5 per share 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 exit prices provided by independent valuation firms, Securities and Exchanges or independent broker dealer quilts 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 overall debt portfolio has a weighted average yield of 10.6%. On March 31, our portfolio consisted of 66 companies across 29 different industries. The portfolio was invested 55% in first lien secured that 28% in second lien secured debts, 4% in subordinated debt and 13% in preferred and common equity. 89% of the portfolio had a floating rate. Now let me turn the call back to Art.

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is to generate an attractive risk adjusted return through income 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 captured that free cash flow primarily in dead 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 in confidence in us. That concludes our remarks. At this time, I'd like to open up the call for questions.

[Operator Instructions] And we'll take our first question from Kyle Joseph with Jefferies.

Hey, good morning, guys and thanks for taking my questions. I just want to get a sense for your thoughts on yields going forward. Obviously, you guys are going through a portfolio makeshift, but on a sort of apples to apples deals and on the same layer of the capital spectrum, what sort of trends are you seeing in terms of yields?

Thanks, Kyle. From an apples to apples basis, I think kind of the first lien is stretch senior that we're doing kind of goes anywhere from L plus 475 to kind of L plus 700 if it's a stretch of your first lien. And those have kind of been consistent over the last two or three quarters. We haven't seen -- we've seen consistency obviously with the volatility in the broadly syndicated market in December. Maybe we saw a moment of increased yields but yields, but things apples to apples are pretty stable.

Got it. And then just from a higher-level industry question, a lot of your peers and yourselves are increasing leverage and kind of adjusting investment styles to a certain extent, just wondering if you're seeing sort of any competitive changes in the industry as the industry late ramps its leverage?

Yes. We, haven't seen any real change. Obviously, capital formation and BDCs has been less robust and publicly traded. BDCs has been less robust in the last few years through the apply fund fees role. So, the biggest capital formation has been in the private sector, private debt structures on a relative basis. The people who are managing both the public BDCs as well as private funds generally have been around a while, are generally rational competitors. Every once in a while you'll see a competitor who's trying to a ramp in some way, shape or form who does stuff that's irrational. But we haven't really seen much of that recently. So, the competitive framework is pretty much consistent as it's been in the last few years. Typically, most of the middle market sponsors have a handful of go-to lenders that they show deals to, who are trusted a lenders to them. And our goal is to get a first look and a last look, our first call in the last look, so to speak, on the deals. And I think generally, we do that and where we want to be part of a deal where we want to lead a deal, we have a very good hit ratio.

Got it. That's helpful. Thanks very much for answering my questions.

All right. And next we'll go to Robert Dunn [ph] with Raymond James.

Looking at obviously the new non-accrual Hollander, any more color you can give us about what the driver was for that getting to a tipping point because obviously you mark so still tends to imply that that they've got good asset coverage. But on the non-accrual side is there any particular telling points that led to that event?

Yes, it's a good question. I think it's indicative a little bit about what's going on in the overall market. People say chi Middle Market M&A levels, activity has been a little bit lighter so far in 2019 and it was an '18 and obviously you typically have a seasonality in the first quarter, but it has been lighter. And we think in part it is because buyers and financers are being more skeptical of the pro forma adjustments. And you see a deal like Hollander where like a lot of deals that we and everybody else do they're roll ups. They're doing an acquisition after acquisition after acquisition and they're trying to consolidate an industry and every once in a while you hit it a bump when you're trying to do a lot. You're trying to do a lot at once and those synergies or those savings don't necessarily come in. So, Hollander we think is a good company. It's the leader in its space of pillows and sheets. And we think in that space, we know it's the leading company, but it was three different companies put together. The last act add on acquisition, the integration did not go well, which is why you have the situation you have today. But this is indicative, Hollander is just one example of kind of the risks of what has gone to the new market and why we think activity levels probably slowing down a little bit in '19 as we and everybody else, buyers and financers look and say, "Hey, before we buy this deal or finance this deal, we really want to do extra diligence on the add on acquisitions and the pro forma adjustments." So, Hollander, unfortunately, hit a road bump because they were trying to do too much at once operationally. It hasn't worked out as well as they would have hoped. So, that deal is in restructuring right now, but it is indicative a little bit of what's going on in the overall market.

Got it. I appreciate that. So, the obvious follow-up question, when you look through the rest of your portfolio, are there any other -- I perceive there are other mobile apps in the portfolio. So, if that's kind of the driver for Hollander, are there any incremental concerns you have about additional assets that are kind of going through the same market dynamic in terms of may be synergies not coming through, maybe rollout not working out, etcetera?

So, what we think -- so Hollander is actually healthy for us and the rest of the market. Obviously, we think the portfolios appropriately, market has been done by an independent valuation firms by and large. We think the markets reflect reality. So, we're not really seeing this happen elsewhere in the PNNT portfolio. And I'll say also on the other hand, to balance it out, we have some very nice cone vests, which, and you can see in the markets as well, which seemed to be indicative of when it does work out like the Decaux pack and Kano and Walker, Edison and Wheel Pro. In some cases we do these equity call invest and when it works out it could be very, very nice on the other hand. So, one of the reasons we do call invest is to help fill in the gap from when we do have some road bumps like we're having in Hollander. So, we think the portfolio both on the debt side and the equity side is obviously appropriately marked, but it's indicative of some of the puts and some of the takes that are going on it. So, we don't see anything near-term really in the rest of PNNT portfolio from the standpoint from rollups. But there could be in the future, but also there could be some nice upside elements from these equity Columbus.

I appreciate that. And then last one, if I can kind of follow-on from that as well. On the equity co-investment, obviously, some of them have got considerable value and obviously not producing income, you don't get to control in general when those are monetized. But what's your view on it is a pretty hot market out there, but selling some of these assets, what's your kind of -- well, I would mention, we've got to tell you about where or what the market's going to be for selling your equities, given the players that may be in control of that and what they're viewing?

So, most cases, these players are middle market financial sponsors. They are economic animals by and large. And so, generally, when you see a markup in the equity as a general proposition, you're within 24 months of some sort of event generally, right? And I think as we look at some of the equity compass we have is a general problem. Now, some cases they may say, "Gee, we see so much value, we're going to hold onto the asset for longer. There's more to do." It might be a 36 months, 48 months old. But generally, when the companies are performing well and they can lock in a nice return that they will do so.

Next, we'll go to a Mickey Schleien with Ladenburg.

Good morning, Art and Aviv, just a couple of questions today. With the forward LIBOR curve currently negatively sloped, I'd like to ask how you're managing downside risk to the portfolio's yield in terms of the trends you're getting in LIBOR floors and whether you're starting to think about possibly doing more fixed rate deals if you can get them or maybe heavy headwinds.

That's a great question Mickey. And boy, a few months makes a big difference in terms of people's views on interest rates. So, the LIBOR floor question's a great question. I think we all have to start looking at it again. I think the implied LIBOR carb doesn't imply that rates are going down a lot, but it doesn't imply that rates are going down some. So, it's something we have to start thinking about. Certainly, as you know, most of our financing or a lot of our financing in this case is a floating rate. So we are matched to some extent assets to liabilities and the SBIC financing is fixed but both are SunTrust and are BNP facility float. So by and large were matched and the SBIC financing of course is attractive financing. But I think you make an excellent point. We should start thinking about it and I think just on the point of kind of doing fixed versus floating, I think the market never really -- you would have thought that as LIBOR increased over the last few years, sponsors and borrowers would have asked us to do fixed and they really did. They really did. So, now it's really up to us to debate. Do we ask for fixed if there's down tick. It's a good question. Can't give you a solid answer on it right now, but something we should certainly be thinking about.

All right, I appreciate that. And I would point out is not always right. Just my follow-up question. Maybe if you could just break out the main components of realized gains and the unrealized appreciation on your investments this quarter.

Sure. So, on PNNT, the big losers from a mark-to-market were Finion Park [ph], as we said, it kind of got a little messy DM, but we're thrilled with the result end-zone to end-zone. And PT network were three key downward movers and mark-to-market MidOcean JNF was up, RAM Energy was up and U.S well was up. So those are -- there wasn't really much on a realized basis. Those were the unrealized ups and down movers.

Okay, and next we'll go to a Ryan A. Lynch with KBW.

Hey, good morning. Thanks for taking my questions. First one was on superior digital. It looked like maybe your dead investment was converted or at least a portion of it was converted to a preferred equity and then written down the quarter. Was there some sort of restructuring or something that one on an investment?

Yes. That investment has underperformed. There was a restructuring in that all investments valued at very low dollar amount at this point. So it's essentially a coming to it's end, it hasn't been pretty, but it's coming to its end.

Okay. And then on RAM, it sounds like they're going to be, now you said they're going to be focused on the Austin chalk assets. Can you just remind us where they involved in multiple areas before this and what kind of drove their opinion to just focus on those assets and if they were involved in other areas where they just plan on selling it off or what is kind of the thought behind that?

Yes. Well, when RAM was started, it had a wide variety of different fields in a wide variety of areas. They did have a concentration in the Austin Chalk and the Austin Chalk position in East Texas seems to be a very attractive position. So, the idea is exit the ancillary positions where you can't get enough concentration focus on the Austin Chalk in East Texas where you can have a concentrated position in an area that looks very, very good. They've drilled three wells in this area and they're all in the top 10 wells in that region, including the top producing wells. So, the region is starting to get some, some focus. The acreage that they have is in the middle of a bunch of strategists [ph] who may want to buy some attractive assets and acreage at some point in time. So, the idea is prove out this eastern Texas Austin Chalk position, drill a few more wells, prove it out a little bit more, and perhaps it will be an attractive ad on acquisition candidate for one of the big strategies that surrounding that area.

Okay, that's really helpful color on that one. And then last question, first congrats on being able to exit the park, investment. But if I'd maybe take a step back and just look at when that investment was originally made in 2014, that was a 15% yielding second lien $77 million investment that you made in PNNT, can you maybe just talk about how PNNT's investment philosophy or maybe investment strategy has evolved over that time period that doesn't seem like an investment you would be making in the entity today. So can you maybe just talk about now that that investment is repaid, it'd be how your investment strategy has kind of shifted a little bit in the recent years?

Yes, and that's a great question. Primary focus in PNNT today is on smaller bites, a more diversified portfolio and generally at the top of the capital stack, first lien or stretch seniors. So we made that investment in different time in a different place. It was a two cons and looking back it was too concentrated. It was a project financing second lien. We, we've had a very good gaming track record and even here, our 13.8%, we're proud of it but I think today the mission of PNNT is by and large top the capital stat, freight diversified, smaller bites; and we're excited about the return we got on park but we're just as excited about how it allows us to pivot and move up to capital stack and have a much more diversified portfolio.

Okay, those are all my questions. I appreciate the time today.

And next we'll go to Casey Alexander with Compass Point Research.

Little bit of a math question here; all of your sleek [ph] products had a 10% coupon, so that's a loss of about $2 million a year of income or $0.03 a share. Also your reinvestment rate, you've been investing new money at about 9% and Park was 14.5% coupon; if you reinvest those proceeds at 9% that's a difference of about $0.06 per share of net investment income. How do you go about replacing what is arguably right now sort of the loss of $0.09 per share or more than 10% of your estimated annual NII?

Yes, I think on the math, I think we will probably call you after the call Casey and go through Hollander, I think he was just saying that your number sounds a bit high. On Park, I think that's really a good question which is -- it's indicative of how we're shifting the portfolio. So, we are happy to get awareness return on Park; and then, overtime -- I mean, we're not going to snap our fingers and immediately replace that income overtime judiciously and prudently move up capital structure to lower risk, lower reward assets, and also judiciously and prudently increase our leverage to the higher target leverage. So the idea is, at the end of the day when the dust clears, we still have an attractive ROE but a safer ROE using a little bit more leverage but being higher in the capital stack. So you're right, I mean, Park is a nice big coupon, it was a big chunky position and we enjoyed the yield of that for a while, and that was great and the thrill we got out of it at a reasonable price and good return. But you know, we're not going to snap our fingers immediately to replace it, thoughtfully, methodically, prudently up capital stack, more diversified bytes, and -- you know, when it does clears, whenever it clears, it might take us a couple of quarters, it might take us two or three quarters, have a lower risk portfolio and a very attractive ROE.

Thank you for that. Secondly, clearly, I don't understand something because the liability structure of PNNT and the liability structure of PFLT or not broadly differentiated, and yet PFLT had a $5 million charge for debt appreciate and PNNT had $3.6 million or $3.7 million gain for debt depreciation. And it's curious how one could have a charge and one could have a gain in the same quarter.

That's an excellent question. So, PFLT as you know, has bonds that trade on the Tel Aviv Stock Exchange, and due to the market movement, those bonds rallied over the quarter. Now let's move over to PNNT; PNNT had bonds which we take out -- took out with a make-whole premium which hit GAAP NII and we replaced that with a drawdown of our credit facility, and what happens it our credit [indiscernible] but it was that the credit facility went up substantially to pay-off the bonds that then PNNT then enjoyed, if you want to call it that, the benefit of the increased NAV because we had a bigger credit facility marked to 98 or 99. I hope that was understandable.

So at some point in time when you paydown that credit facility, it will result in debt appreciation that would resulted in charge against earnings at some future day?

That's right, and then we'll have a new credit facility and the same thing will happen.

Thank you very much. I appreciate you answering my questions.

All right, Casey. Thank you so much. Operator, I think that's all of our questions. So, look I'd like to thank everybody for being on the call today, we really appreciate it, and we'll be chatting with you in early August at our next conference call. Thank you very much.

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