PennantPark Investment Corporation (PNNT) Q3 2021 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2021 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's 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.

Good morning, everyone. I'd like to welcome you to PennantPark Investment Corporation's third fiscal quarter 2021 earnings conference call. I'm joined today by Richard Cheung, our new Chief Financial Officer. Richard joined us in June from Guggenheim Partners, where he was Head of Alternative Investment Accounting for many years. Prior to Guggenheim, he was at E&Y. We are thrilled that Richard has joined us and are confident that his extensive experience will be a tremendous asset for the company. We thank Aviv Efrat for all his contributions to PNNT since inception and are grateful that he is continuing with PennantPark focusing on strategic initiatives. Richard, 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 the 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 a telephone numbers and pin provided in our earnings press release as well as on our website. I'd also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today's conference call may also include forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website at pennantpark.com or call us at (212) 901-1000. At this time, I'd like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Thanks, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, our capital structure and liquidity, the financials, and then open it up for Q&A. We are pleased with our performance this past quarter. We achieved a 4.1% increase in adjusted NAV. Adjusted NAV went up $0.38 per share from $9.20 to $9.58 per share. We are particularly pleased that our NAV today is up over 9% from what it was pre-COVID on December 31, 2019. We have several portfolio companies in which our equity investments have materially appreciated in value as they are benefiting from the recovery. This is solidifying and bolstering our NAV, we will highlight those companies in a few minutes. Additionally, we are making progress in our equity rotation program. During the quarter, we generated $51 million of cash proceeds from the equity portfolio, including proceeds from Wheel Pros, Walker Edison, DecoPac, WVB, Cano, and others. As part of our business model, alongside the debt investments we make, we selectively choose to co-invest in the equity side-by-side with the financial sponsor. Our returns on these equity co-investments have been excellent over time. Overall for our platform, from inception through June 30, our $237 million of equity co-investments have generated an IRR of 28% and a multiple on invested capital of 2.9x. In a world where investors may want to understand differentiation among middle market lenders, our long-term returns on our equity co-investment program are a clear differentiator. Our core net investment income was $0.14 per share, which excludes $1.1 million of one-time expenses in connection with the prepayment, of a portion of our SBIC financing. With regard to growing net investment income, we have a three-pronged strategy, which includes; number one, growing assets on balance sheet at PNNT as we move towards our target leverage ratio of 1.25x, debt-to-equity from 0.8x; number two, growing our PSLF JV with Pantheon to about $550 million of assets from approximately $400 million of assets through balance sheet optimization, including a potential securitization; and three, the opportunity to rotate out of our equity investments over time into yield instruments. We are well on our way to implementing the NII growth strategy. In addition to generating $51 million of cash proceeds from our equity portfolio this past June quarter, since June 30, PNNT has had new originations of $69 million. Although in the June quarter, repayments on loans roughly equaled new loan originations and the September quarter so far repayment activity has abated and new originations have accelerated. Our portfolio performance remains strong. As of June 30, average debt-to-EBITDA on the portfolio was 4.6x and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense was 3.4x. We have no non-accruals on our books in PNNT and PSLF. The portfolio is highly diversified with 86 companies and 29 different industries. Since inception, PNNT has invested $6.2 billion at an average yield of 12%. This compares to a loss ratio of about 15 basis points annually. This strong track record includes our energy investments, our primarily subordinated debt investments made prior to the financial crisis, and now the pandemic. As we analyzed our 14-year track record of PNNT, it is clear our returns took a step function up starting in 2015. The IRR of our investments made prior to 2015 was 9.7%. Since 2015, we have achieved a 13.8% IRR. We believe this is due to four key factors. Number one, better company selection within industry verticals where we have domain expertise; number two, avoidance of investments in the energy industry and other cyclicals; number three, excellent results from our equity co-investment program; and number four, a substantially increased focus on core middle market companies where our capital can be more important to companies. Core middle market to us means below $50 million of EBITDA. According to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate and higher recovery rate than loans to companies with EBITDA higher than $50 million. Our performance through the global financial crisis and recession was excellent. During that recession, the weighted average EBITDA of our underlying portfolio companies declined by 7.2% at the bottom of the recession. This compares to the average EBITDA decline of the Bloomberg North American High Yield Index of 42%. Based on tracking EBITDA of our underlying companies through COVID, our EBITDA decline was substantially less than it was during the global financial crisis. Our median EBITDA declined at the bottom of COVID in June 2020 was 1.4%. This compares favorably to the 7% decline in EBITDA during COVID of the Credit Suisse High Yield Index. Many of our companies are in industries such as government services, healthcare, technology, software, business services, and select consumer companies where we have meaningful domain expertise. We believe that we are experiencing strong recovery with some companies and industries being beneficiaries of the environment. We are pleased that we have significant equity investments in several of these companies, which can substantially move the needle of our NAV. I would like to highlight some of those companies; the companies are Cano, Walker Edison, PT Network, and JF Petroleum. Cano Health is a national leader in primary healthcare, who is leading the way in transforming healthcare to provide high-quality care at a reasonable cost to a large population. Our equity position has a cost and fair market value on June 30 of zero and $61 million, respectively. Walker Edison is a leading e-commerce platform focused on selling furniture exclusively online through top e-commerce companies. Our equity position has a cost of zero and a fair market value of $9.5 million as of June 30. Due to two capital transactions, one in dividend recap and another in equity financing by Blackstone, we have received cash equal to 4x our capital on our equity position. PT Network is the leading physical and occupational therapy provider in the Mid-Atlantic States. Our equity position has a cost of $23 million and a fair market value of $60 million as of June 30. MidOcean JF Holdings or JF Petroleum, is a leader in the distribution, installation and servicing of vehicle fueling, and related equipment to retail fueling locations in the U.S. As of June 30, PNNT owned equity securities with a cost and fair market value of $40 million and $49 million, respectively. These companies are gaining financial momentum in this environment and our NAV should be solidified and bolstered from these substantial equity investments as their momentum continues. PNNT has among its lowest percentage of energy investments since 2013. Energy investments represent only 7% of the overall portfolio. RAM is now on stable operational and financial footing and has benefited from higher prices and production. The company is free cash flow positive after debt service and plans to use any cash flow to repay debt. As of June 30, equity represented approximately 35% of the portfolio. Equity investments held for the past 12 months have appreciated by approximately 45%, driven by many of the companies previously mentioned. Our long-term goal continues to target that percentage down to about 10% of the portfolio. As we monetize the equity portfolio, we are looking forward to investing the cash and to yielding debt instruments to increase net investment income. The outlook for new loans is attractive. We are as busy as we've ever been in 14 years in business, reviewing and doing new deals. With our experienced, talented and growing team, our wide funnel is producing active deal flow that we can then carefully and thoughtfully analyze so that we can be selective as to what ends up in our portfolio. We are focused on the core middle market, which we generally define as companies with between $10 million and $50 million of EBITDA. We like the core middle market because it is below the threshold and does not compete with a broadly syndicated loan or high yield markets. As such, we do not compete with markets where leverage is higher, equity cushion is lower, covenants are light, wide or nonexistent, information rights are fewer and EBITDA adjustments are higher and less diligence and the timeframe for making an investment decision is compressed. On the other hand, where we focus in the core middle market, generally our capital is more important to the borrower. As such, leverage is lower, equity cushion is higher, we have real quarterly maintenance covenants, we receive monthly financial statements to be on top of these companies, EBITDA adjustments are more diligent and achievable and we typically have six to eight weeks to make thoughtful and careful investment decisions. As we highlighted a moment ago, according to S&P, loans to companies with less than $50 million of EBITDA have a lower default rate and a higher recovery rate than those loans to companies with higher EBITDA. Let me now turn the call over to Richard, our CFO, to take us through the financial results.

Thank you, Art. For the quarter ended June 30, core net investment income totaled $0.14 per share, excluding $0.02 per share of SBIC prepayment fees. Looking at some of the expense categories, base fees totaled $4.4 million, taxes, general and administrative expenses totaled $1 million, and interest expense totaled $7 million, including one-time expenses from the prepayment of SBIC financing. Net realized gains on investments was $42 million or $0.62 per share. Change in the net unrealized loss in our investments was $60 million or $0.25 per share. Change in the value of our credit facility decreased our NAV by $0.02 per share. Our net investment income equaled our dividend. Consequently, NAV per share went from $9.24 per share to $9.59 per share, up 3.8% from the prior quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $9.58 per share, up 4.1% from $9.20 per share in the prior quarter. 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, security, and exchanges or independent broker-dealer quotes 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 GAAP debt-to-equity ratio, net of cash was 0.8x. Regulatory debt-to-equity ratio, net of cash which excludes SBIC debt was 0.7x. We have a strong capital structure with diversified funding sources and no near-term maturities. We have $435 million revolving credit facility maturing in 2024 with a syndicate of banks, $64 million of SBA debentures maturing in 2027 and 2028, $86 million of unsecured notes maturing in 2024, and $150 million of unsecured notes maturing in 2026. Our overall debt portfolio has a weighted average yield of 9.2%. On June 30, our portfolio consisted of 86 companies across 29 different industries. The portfolio was invested 41% in first lien secured debt, 14% in second lien secured debt, 10% in subordinated debt, including 6% in PSLF, and 35% in preferred and common equity, including 4% in PSLF, 91% of the portfolio has a floating rate, all of which has a LIBOR floor. The average LIBOR floor is 1%. Now let me turn the call back to Art.

Thanks, Richard. To conclude, we want to reiterate our mission. Our goal is to generate attractive risk-adjusted returns through income, coupled with long-term preservation and 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 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 up the call for questions.

Thank you. [Operator instructions] We can now take our first question from Casey Alexander with Compass Point. Please go ahead.

Hi. Good morning, and thank you for taking my questions – or good afternoon, I guess it is. Can you tell us what the current outstanding debt is on RAM and using the current price decks, energy price decks is a baseline, to what extent can you pay that down quarter-by-quarter?

Thanks, Casey. And it's a good question. It’s about $40 million of debt on the balance sheet of RAM. We can pay it down over the course of the next two or three years. It's a very attractive long-term loan from the Fed Main Street program. So as we generate cash flow, we have the option to either pay it down or just accumulate cash on the balance sheet. So we'll evaluate things as they go. But it is cash flow generative. The company is generating good cash flow today.

So just to make sure that I understand your answer, that if you dedicated the excess cash flow to paying down the debt, you could have it paid off in two to three years?

Yes.

Yes. Okay, great. That's very helpful. Secondly, given that – I mean, your return of NAV to above pre-COVID levels, and yet the extreme discount in the stock, is there any consideration towards even a modest share repurchase program to take advantage of the discount? I mean, it's the highest in the peer group and yet your returns seem to be improving and NAV is clearly improved and perhaps that would be a useful way to take advantage of it for shareholders?

Yes. It's a great question, and we're always considering and I think as we generate a $51 million of proceeds on from equity investments this past quarter. I'm hopeful that as – those continue and get even greater, we certainly would look at taking a portion of the proceeds. So hopefully it will be a lot greater than the $51 million and dedicate a portion of that over time to buying back the stock. So we got to play it out. We got to start generating these proceeds over the coming quarters. And I would certainly, if the stock price continues to be where it is certainly consider – we would certainly consider dedicating a portion of hopefully bigger proceeds to very worthwhile investment of the stock.

All right. Great. Thank you for taking my questions.

And we can now take our next question from Robert Dodd, Raymond James. Please go ahead.

Hi, guys. Yes, good afternoon. For the capital structure, obviously you've been paying down the SBA debt and obviously you just did an unsecured bond. So your unsecured is a good portion – a very healthy portion of the mix. I mean, can you give us any idea where you like the mix of debt to be and should we expect the SBA to continue to shrink, you've only got two pools of debentures left, I think in that $64 million, is that going to be contemplated to be paid off ahead of maturity, which obviously maturity is a way out there?

Yes, so it's a good question. And the way the SBIC financing works is as you get towards the back end of the pool, which we are. You're not really permitted to make new investments from that. So you can just sit there with cash and pay the interest expense or you can pay it off, which is why we elected to payoff about $45 million this quarter. So yes, the SBIC will wind down over the coming quarters or years. We like unsecured financing, particularly these types of levels we did a deal, not too long ago, which was well received. So over time we're going to use unsecured probably to a greater extent targeting about 33% of the debt stack as unsecured. And we also like securitization technology. We haven't yet used it in PNNT, we've used it in the sister BDC, PFLT. But we certainly liked the long-term low cost of securitization. We like the long-term unsecured nature of bonds. And then the other piece of it, of course, will be plain old credit facilities, which is kind of what we already have. So over time expect us to increase unsecured, expect us to potentially utilize securitization both in our JV, as well as on balance sheet at PNNT. And I think that's the game plan at this point in time.

Got it. And the next question, within the JV, obviously you mentioned potentially using a securitizations in that. What would given generally securitizations do within the JV would allow a higher leverage that would be carried on the balance sheet. What's the target level? What are the usage of securitization technology? Should we expect that to result in higher leverage, I mean third-party debt, not including your sub debts at the JV or is the target leverage still kind of 1.5x within that vehicle?

Yes. So you can look again at the corollary at our joint venture over PFLT where we did a securitization as a joint venture and we are contemplating using that because the securitization does give you very long-term safe financing and you can sleep at night with our long-term securitization. We would contemplate potentially doing the same thing at our joint venture here with Pantheon PSLF. And you could contemplate, I'll just throw out a straw man with the same amount of junior capital that we currently have in that joint venture, getting to a portfolio of, call it, $570 million, $580 million, something like 2.3x leverage to junior capital, which could be very helpful from an ROE standpoint and generating nice NII for PNNT. So that's just one straw man that one could contemplate, similar to what we're doing over at PFLT.

Understood. One more if I can kind of following up to Casey's question. With RAM still sizable, still equity, M&A market in oil and gas seems to be starting up. I mean I’m not an expert on that particular leash obviously, but any M&A activity beginning to happen within the Austin Chalk or anything on that that might make it RAM tech monetization because it’s a big slug of capital, more likely in the not too near future, but…

We hope so. It's early days, but we're hopeful and yes, we are not going to wait for the last dollar, if there's a good nice monetization event. We like our shareholders will look to convert the equity to cash. Of course, we will not be perfect market timers. That said it's still early, right. It's still early. When you see more robust M&A, when you see more drilling, I mean, ultimately some other oil and gas companies should be able to say, I have an option to drill, or I have an option to do an M&A deal with someone like RAM. And because RAM has a very well delineated acreage and 12 holes in the ground that had been very productive that's a really good use of shareholder investor cash to buy RAM. So now everyday you’re reading the newspapers, the big companies are being very judicious and careful, they're not drilling and they've got the discipline and all this other stuff. So when that's – I don't want to say no and we're ready to be able to be undisciplined, but we are waiting for them to feel a little bit more expansive about doing things, whether that be drilling, whether that be M&A and we look forward to that day and we will try to optimize value and as expeditious a timeframe as possible.

Got it. Thank you, and congrats on the new quarter.

[Operator Instructions] We can now take our next question from Ryan Lynch of KBW. Please go ahead.

Good afternoon, Art, and congrats on the nice quarter. My first question has to do with the equity co-investment strategy. Obviously that's been a really successful strategy in the past. I'm just curious with the size of your equity portfolio today and the way it has been really for the last several quarters, have you guys modified that equity co-investment strategy at all? Or are you guys still trying to take equity co-investments as much as you can on new investments? And the nice start of exiting proceeds from the recent equity investments of $51 million, does that help to use that and allow you to be more a little aggressive in that area?

Yes. It's a great question. And it's a little bit of a conundrum. Last quarter equity was about 35% of our book. This quarter is about 35% of our book, but we took $51 million of cash, and then we had markups. So I guess that's good, right? That's good. So we're generating cash and we've had valuation increases at the same time as we want to try to get more exits and try to work that percentage of the portfolio down. So I guess we'll take increases in NAV and cash proceeds all day long, if we can do that. So short answer long, we're just going to continue what we're doing on the equity co-invests. None of these investments are ever that large and individuality. Cano across our platform originally was $8 million or $9 million and that's across different vehicles, right. So Wheel Pros was like $4 million or $5 million across different vehicles. So no one of these co-invests were that large to weigh down PNNT or PFLT or any of our other vehicles. If they do start – if they do well, then they weigh them down, but that's kind of a good weigh down because kind of $5 million becomes $50 million or whatever. So we really haven't adjusted because each individual investment we make is not that big. So just to answer your question, but it's something we're cognizant of. And frankly, when it works well, it would be wrong for us. It's been working well. So it would be wrong for us to not continue that. PNNT itself got weighed down with the energy investments we made bunch of years ago, and we're not doing those anymore. So we still have to work our way out of this, but I think we see the light at the end of the tunnel. We see the pathway. We're encouraged with our results recently and then the way we've been investing really since 2015, where we saw a 400 basis point increase in our IRRs due to a lot of factors. So if they broke, don't fix it. In the meantime, we got to clean up the mess that was created before.

Yes. I think that makes a lot of sense. And Art, I think shareholders would welcome taking on from every quarter by having significant cash proceeds, but not having – the equity book go down given that the rise in fair values and that’s obviously a good place to be. The second question that I had may require you to – crystal ball a little bit, you mentioned $69 million of new originations are quarter-to-date in the September quarter. You said repayments have sort of abated, which was not the case really in the June quarter ended. I'm just wondering, given how active the markets are broadly, do you expect the repayments to kind of stay at that lower level or do you think that's just a little blip and it's more likely than not that they will kind of advance back to higher levels in kind of concert with just higher market activity going on right now?

Yes. So I'll try my best on the crystal ball. And I'm just giving you kind of news flashes off of what we're looking at week-by-week as we bring deals through investment committee. And I'm theorizing now. But I think a lot of the reduction in repayments is due to the fact that we're now getting more mature in this cycle. And the first wave of deals were refinancings, repayments, M&A. So if you pick one company DecoPac, which is a company that we were in for awhile and is a nice company, that company got sold, it got sold to a bigger buyout shops financed by a bigger private lender. And it's a really nice company, but when we got involved with it three or four years ago, we were part of the first institutional capital of a family owned business. The family sold their company to a private equity firm. We financed that deal. And this M&A trade that just happened a couple months ago is the next iteration as the company got bigger more mature and went to a different portion of this direct lending private equity ecosystem. And I think that's a lot of what you've been seeing over the last six months as COVID as kind of hopefully abated a little bit. The deals we're seeing that are coming in the door these days are kind of the next phase of this, which are back to companies that – it's their first time in this direct lending private equity ecosystem. It's a founder, it's a family, it's an entrepreneur and the private equity firm that we're backing. It's the first institutional capital. And our debt is the first institutional debt on that balance sheet. So this is my theory as to why we're seeing less repayment so far. We'll see if it continues, but big part of what we do is finding those situations where – it's the first institutional capital in a business, company does 10, 15, 20 of EBITDA. The sponsor has both inorganic and organic plants to take that EBITDA to 30, 40, 50, 70. Our debt capital will hopefully help fuel that growth and our equity co-invest will ride alongside and generate some upside. So I think we're seeing more of those deals walk in the door, which will hopefully be new part of the direct lending private equity ecosystem for years to come.

Okay. Yes. I appreciate that. That's all processed. It’s a possible question to answer with any clarity, but that's helpful. Those were all my questions. I appreciate your time this afternoon.

Thank you.

We can now take our next question from Kyle Joseph with Jefferies. Please go ahead.

Yes, good afternoon. Thanks for taking my questions. Most have been asked, but just wanted to pick your brain and get your sense for the revenue and EBITDA growth. You guys are kind of seeing currently and where you expect that to go over the remainder of the year as we lap some of the COVID comps?

It's a phenomenal question because – with a big chunk of the portfolio year-ago everything was shut down. So never in my 35 years in the business, I’ve been seeing, revenues up 300% and EBITDA is up 400%, which is kind a some of the situations you're getting in this environment, it's kind a like hopefully we will never see this again in our time. We may, but obviously in many of these cases, the year-on-year growth is tremendous. I think as I indicated in our prepared remarks. We tracked EBITDA down through the – and I'm searching for my piece of paper. We tracked EBITDA down through the cycle on a median basis. It was only down really less than 2% to the bottom. In our portfolio the bottom was June 30, 2020. So that was kind of the bottom point. I'm searching around, I get back to you Kyle on what we've seen since then, but clearly we've seen rapid growth. We've seen – and certainly the most rapid growth has been in the more COVID impacted names by definition. So it's hard to – I really need to get back to you with kind of a statistic and this is something that we can generate over the coming days and weeks. How does it look versus 2019? How does the EBITDA of the portfolio to the extent it's name for names, to the extent we had a name in 2019 than we have it in 2021? What is EBITDA look like relative to that? I would say by definition given the NAV trends it's up substantially, but I would only be guessing. So if I could – you give me a little time, I can call you back and we can certainly disclose it on the next conference call kind of tracking 2021 versus 2019 and give you a sense of kind of how it's looking on a portfolio basis.

Got it. Yes. That makes sense. And then one follow-up for me. Just looking at the yield on the portfolio, again, little bit of a crystal ball question here with a lot of moving parts and rates and spreads and everything, and also kind of the mix shift as you rotate equity, but just how do you think about the yield on portfolio given portfolio rotation and kind of spreads you're seeing in market right now?

Yes, I mean, we see stable yields and spreads. So we're not seeing diminishing of the spreads and yields at this point. They've bounced back for sure. We are kind of more – we are now back to a more “normal” basis. I think what we're seeing though, that's better is the quality of the companies. The companies that we're financing today, by definition and well through COVID there, in some cases they did better through COVID. So even though spreads and yields are maybe creeping back to pre-COVID levels, the quality of the companies is better and the results seem to be on the uptake and the uptrend. So we can play a little bit more offensive aggressively on that. So the game for us really is to continue to select really good credits, lessons that we continually learn are it's all about the company find really good companies. And if you stretch a little bit on leverage, if you stretch a little bit on yield, if you find really good companies, it all works. So we got to find really good companies. We're finding some a lot today, utilize the various levers we have available to us in terms of leveraging up the PNNT balance sheet, leveraging up the PSLF joint venture balance sheet and working the equity rotation. Those are the three levers, and if we can continue to find quality deal flow with high quality companies, we should be able to substantially grow NII and also hopefully ride some NAV leftover time with a chunk of our portfolio that's in equity securities.

Got it. Very helpful. Thanks a lot for answering my questions.

Thank you, Kyle.

And we have no further questions at this time. I would like to hand the call back to Mr. Penn for closing remarks.

Thanks everybody for being on the call. We wish everybody a enjoyable and hopefully very healthy rest of the summer. Our next quarterly conference call will be in mid-November for our 10-K, it's the September 30, 10-K that we'll be filing in mid-November. So look forward to speaking to people then if not between now and then. Have a great summer everybody. Thank you.

This concludes today's call. Thank you for your participation. You may now disconnect.