PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q3 2024 Earnings Call Transcript

PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q3 2024 Earnings Call Transcript August 8, 2024

Operator: Good morning and welcome to the PennantPark Floating Rate Capital’s Third Fiscal Quarter 2024 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 Floating Rate Capital. Mr. Penn, you may now begin your conference.

Arthur Penn: Thank you and good morning, everyone. I’d like to welcome you to PennantPark Floating Rate Capital’s third fiscal quarter 2024 earnings conference call. I’m joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

Richard Allorto: 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 Floating Rate Capital and that any unauthorized broadcast of this call in any form is strictly prohibited. An audio replay of the call will be available 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 212-905-1000. At this time, I’d like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Arthur Penn: Thanks, Rick. We’re going to spend a few minutes discussing the current market environment for private middle market lending, how we fared in the quarter ended June 30, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials, and then open it up for Q&A. For the quarter ended June 30, GAAP and core net investment income was $0.31 per share. As of June 30, our portfolio grew to $1.7 billion, or 12% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities, and invested $321 million in 11 new and 47 existing portfolio companies at a weighted average yield of 11.5%. We continue to see an attractive vintage in the core middle market.

For investments in new portfolio companies, the weighted average debt to EBITDA was 3.8x, the weighted average interest coverage was 2.2x, and the weighted average loan to value was 47%. Subsequent to quarter end, we remained active and invested over $115 million at a weighted average yield of 11.2%. Investment volume is increasing, and we have a robust pipeline and expect the second half of 2024 to be active. During 2024, the market yield on first lien loans has tightened 50 to 75 basis points. As the credit statistics just highlighted indicate, we continue to believe that the current vintage of core middle market loans is excellent. And the core middle market, leverage is lower, spreads are higher, and covenants are tighter than in the upper middle market.

Despite covenant erosion in the upper middle market and the core middle market, we are still getting meaningful covenant protections. As of June 30, our debt-to-equity ratio was 1.1x to 1. With a target ratio of 1.5x to 1, we believe that we are well positioned to drive additional growth in net investment income going forward. Securitization financing continues to be a good match for our lower risk first lien assets. Subsequent to quarter end, PFLT closed on the refinancing and upsize of a $351 million term loan, term debt securitization transaction with a weighted average spread of 1.89%, a four-year reinvestment period, and a 12-year final maturity. The weighted average spread of 1.89% is a meaningful decrease of 50 basis points from the prior level of 2.39%.

The main contributor to this decrease was a favorable market environment in which the AAA portion of the structure priced at an attractive weighted average spread of 1.75%. The ratio of external debt to PFLT’s junior capital was 3.1x to 1, which creates plenty of liquidity for the company. During the quarter, we added two new lenders to the Truist Revolving Credit Facility and upsized total commitments to $611 million from $436 million. In addition, this week we expect to close on an amendment, an extension of the Truist Revolving Credit Facility. The highlights of the amendment are an increase in total commitments to $636 million, a reduction in rate to SOFR plus 225, which is down from SOFR plus 236, and an extension in the revolving period to 2027.

We expect continued stability in NII in part due to our investment in the joint venture. As of June 30, the JV portfolio totaled $904 million, and together with our JV partner, we continue to execute on the plan to grow the JV portfolio to approximately $1 billion of assets. During the quarter, the JV invested $85 million in five new and 11 existing portfolio companies at a weighted average yield of 11.6%, including 69 million of assets purchased from PFLT. We believe that the increase in scale of the JV’s balance sheet will continue to drive attractive mid-teens returns on invested capital and enhance PFLT’s earnings momentum. GAAP and adjusted NAV decreased 0.5% to $11.34 per share from $11.40 per share. The decrease in NAV for the quarter was due primarily to valuation adjustments on both debt and equity investments.

Credit quality of the portfolio has remained strong. We added two new investments to the nonaccrual status. Nonaccruals represent only 1.5% of the portfolio cost and 1.1% at market value. As of June 30, the portfolio’s weighted average leverage ratio through our debt security was 4.1x, and the portfolio’s weighted average interest coverage ratio was 2.2x. We believe that this is one of the most conservatively structured portfolios in the direct lending industry as a testament to our focus on the core middle market. We like being positioned for capital preservation as a senior secured, first lien lender focused on the United States. We continue to believe that our focus on the core middle market provides the company with attractive investment opportunities where we provide important strategic capital to our borrowers.

We have a long-term track record of generating value by successfully financing growing middle market companies in five key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask, and have an excellent track record. There are business services, consumer, government services and defense, healthcare, and software technology. These sectors have also been resilient and tend to generate strong free cash flow. The core middle market, companies with $10 million to $50 million of EBITDA, is below the threshold and does not compete with the broadly syndicated loan or high-yield markets, unlike our peers in the upper middle market. In the core middle market, because we are an important strategic lending partner, the process and package of terms we receive is attractive.

We have many weeks to do our diligence with care. We thoughtfully structure transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, and equity co-investments. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated personal loans have meaningful covenants which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. Many of our peers who focus on the upper middle market state that those bigger companies are less risky. That may make some intuitive sense, but the reality is different.

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 higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence, and tighter monitoring have been an important part of this differentiated performance. Our credit quality since inception over 13 years ago has been excellent. PFLT has invested $6.3 billion in over 500 companies, and we have experienced only 20 nonaccruals. Since inception, PFLT’s loss ratio on investment capital is only 10 basis points annually. As a provider of strategic capital, it fuels the growth of our portfolio companies. In many cases, we participate in the upside of the company by making an equity co-investment.

Our returns on these equity co-investments have been excellent over time. Overall, for our platform from inception through June 30, we have invested over $511 million in equity co-investments, and have generated an IRR of 26% and a multiple on invested capital of 2x. Our experienced and talented team and our wide origination funnel is producing active deal flow. Our continued focus remains on capital preservation and being patient investors. Our mission and goal are a steady, stable, and protected dividend stream coupled with the preservation of capital. Everything we do is aligned to that goal. We seek to find investment opportunities in growing middle market companies that have high free cash flow conversion. We capture that free cash flow primarily in first lien, junior security instruments, and we pay out those contractual cash flows in the form of dividends to our shareholders.

Let me now turn the call over to Rick, our CFO, to take us through the financial results in more detail.

Richard Allorto: Thank you, Art. For the quarter ended June 30, GAAP and core net investment income was $0.31 per share. Operating expenses for the quarter were as follows. Interest and expenses on debt were $16.4 million. Base management and performance-based incentive fees were $9.2 million. General and administrative expenses were $1.5 million. And provision for taxes were $0.2 million. For the quarter ended June 30, net realized and unrealized change on investments, including provision for taxes, was a loss of $4.3 million. As of June 30, our GAAP NAV was $11.34 per share, which is down 0.5% from $11.40 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities, was $11.34 per share, down 0.5% from $11.40 per share last quarter.

As of June 30, our debt-to-equity ratio was 1.1x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of June 30, our key portfolio statistics were as follows. Our portfolio remains highly diversified with 151 companies across 45 different industries. The weighted average yield on our debt investments was 12.1%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 1.4% of total interest income for the quarter. We had three nonaccruals, which represented 1.5% of the portfolio at cost and 1.1% at market value. The portfolio is comprised of 87% first lien, senior secured debt, less than 1% in second lien and subordinated debt, 4% in equity of PSSL, and 9% in other equity.

The debt-to-EBITDA on the portfolio is 4.1x, and interest coverage was 2.2x. Now let me turn the call back to Art.

Arthur Penn: Thanks, Rick. In closing, I’d like to thank our dedicated and talented team of professionals for their continued commitment to PFLT and its shareholders. Thank you all for your time today and for your investment and confidence in us. That concludes our remarks at this time. I would like to open up the call to questions.

Q&A Session

Operator: [Operator Instructions] We’ll take our first question from Brian McKenna from Citizens JMP.

Brian McKenna: It was another strong quarter of growth for the investment portfolio, and that’s actually now increased 55% year-to-date. So what’s the expectation around growth for the portfolio over the next couple of quarters? You still have capacity on the leverage side, and then cash also remains somewhat elevated. So I’m just trying to think through the trajectory of the portfolio from here, and ultimately, if you’re actually in a position to grow earnings into next year, even with what’s likely going to be lower base rates.

Arthur Penn: Yes, thank you. It’s the right question, and I’ve got to say we’re busy. We’re busy. We’ve been busy, obviously, the last quarter or two, maybe somewhat differentiated than some of our peers who are in the upper-middle market where it’s been either slower or they have severe competition going against the broadly syndicated loan market. Here in the core-middle market, we’re active. We’re seeing a lot of deal flow. We’re kind of doing our prototypical start with a platform that’s a little smaller but with add-on acquisitions, delayed raw term loans, substantial equity from the sponsor, and grow it over time. So that’s a lot of what we’re doing. Hard to put a pin in it for you, Brian, in terms of actual capital deployed.

We’ve built a very nice war chest between the upsized Truist facility, a couple hundred million dollar upsize, the upsized securitization, and the ATM program. So really well positioned from the liquidity and capital side to take advantage of the opportunity. And should the markets become choppier, and that’s certainly a possibility, having capital to be able to take advantage of that should that happen. So I feel like we’re in a really good position, liquidity-wise and capital-wise, to grow. Certainly in terms of NII per share as we lever up, that should fall to the bottom line. So we’re trying to find the balance of keeping a lot of powder dry to take advantage of the vintage, to take advantage of the opportunity, and also to leverage up and drive NII per share up.

Brian McKenna: Okay. Super helpful. Thanks. And then just to follow up on leverage specifically, so you’ve clearly leaned into the ATM the last several quarters, and that’s been a big driver of leverage being quite a bit below that target range. So given where the stock is trading today, I’m assuming you’ll shy away from raising equity capital, and then leverage will start to move higher. But is there just a way to think about kind of the timeline around getting back to that one-and-a-half times leverage target?

Arthur Penn: Yes, it’s a good question. Look, with the stock where it is today relative to NAV, that would be diluted. We would not issue shares. We would not do that. We’re very pleased that we did. The last round of ATM, we raised it around $11.40, so feel good about that. Today is the time to deploy that capital and the capital we’ve built on the credit facility side, on the CLO side. So I think right now we kind of timed it propitiously or whatever, and now is the time to kind of deploy and use the capital to take advantage of the opportunity.

Brian McKenna: Okay, great. And then, Art, just one more bigger picture question for you. You’ve clearly operated the business through a number of different cycles and operating environments, and the macro today remains very fluid, and there’s quite a bit of uncertainty just around kind of the broader economic outlook into 2025. So I’m curious, what are your broader thoughts on where we are in the cycle, what this evolving macro means for your business, and then are you leaning in on, any of your past experiences to make sure that PFLT remains well-positioned to deliver strong results for all stakeholders?

Arthur Penn: Yes, thank you. Look, we have been in business. We’re going into our 18th year, so we’ve lived through the global financial crisis, a industrial downturn in the middle of the last decade, the pandemic. And, most of it still comes down to the micro versus the macro, the micro being select excellent companies, keep the leverage low and sensible, structure good packages, including meaningful covenants. And if you do that, while maintaining liquidity at the vehicle level, making sure you have dry powder to defend and to play offense, the rest of it usually takes care of itself. So that’s kind of lessons from many years in the business. Hard to say whether we’re going into a recession or not. Any good credit underwriter always underwrites deals with a recession case in the underwriting package.

Let’s assume there’s a recession. What happens? What are the levers the company has to pull? How much costs are variable? How much are fixed? Can CapEx be managed? Working capital be managed? So, PFLT has about 150 names. If you go back to the credit memos on all of them, we had downside cases. We had recession cases in all of them. And so, of course you always can get surprised, but generally we have pretty solid packages, and you’re seeing it in the portfolio. Nonaccruals are very low. When we do have nonaccruals, they’re usually idiosyncratic. And even our consumer names, and we have some consumer in the portfolio, are generally performing just fine right now.

Operator: We will take our next question from Doug Harter from UBS. Please go ahead.

Doug Harter: Can you talk a little bit about the competition you’re seeing on new loans, both in terms of spreads and covenant packages?

Arthur Penn: Sure, Doug. Thank you. So spreads, as we said in the prepared remarks, are down over the course of the year, over the course of 2024. We’re now in August. 50 in some cases, 75 basis points. That’s driven by some of our peers. That’s driven by what’s been a stable, sanguine environment. That’s been driven by high base rates. When you’re still getting 11 plus percent on a first lien, on an absolute basis, that’s still attractive for investors, even though the spread, obviously, is tighter than it was nine months ago. So we have seen spread tightening. That said, as we kind of reviewed the statistics in the prepared remarks, we are getting really nice packages. So we still think it’s an attractive vintage. Average debt to EBITDA on the new loans was 3.8x.

Average interest coverage 2.2x, even in these elevated rates. And the weighted average loan to value of 47%. And we are getting meaningful covenant protections. That’s one thing you get in the core middle market that you may not get in the upper middle market is covenants that are meaningful, that are quarterly maintenance tests that the companies have to meet. And if they don’t meet them, there’s a conversation. Additionally, the overall structures are much stronger structures. There’s been a lot of press on some of the names in the upper middle market and some of that, I’ll call it shenanigans, that went on with moving intellectual property around and getting assets away from the lenders, et cetera. None of that happens in the core middle market.

It’s just not allowed, because the upper middle market went covenant light and had to compete with a broadly syndicated space. That was just a market they had to absorb. In our market, these are very strong structures. So we feel very good about the vintage to date. Even though the spreads are down, we feel very good about the credits and the yields. And non-accruals continue to be light and the portfolio is generally performing very well.

Operator: We will now move to Maxwell Fritscher from Truist Securities. Please go ahead.

Maxwell Fritscher: I’m on for Mark Hughes. Kind of going off the competition question, you mentioned all the benefits of operating in the core middle market. Are you seeing any of those competitors from the upper middle market or the middle market come downstream a little bit to tap these better loan values and better covenants?

Arthur Penn: It’s a great question. We have not seen a lot of evidence of the big players moving down into the core. Now, it depends how you define core. We define core as 10 to 50 EBITDA. Occasionally, you’ll see some of the big guys come down to a 40 or 50 EBITDA company. They can deploy a couple hundred million in one check, but that’s occasional. And many of our deals, our prototypical situation is, it’s a company that’s doing 10 to 20, and it’s a fragmented industry. There’s a game plan. There’s identified acquisitions for growth. And the goal is to take that 10 million to 20 million EBITDA company and grow it to 30, 40, 50 and above. So we’ll be that lender that’s strategic to the borrower. We will provide delayed draw term loan and a pathway to get that company larger.

And so if we’re doing that, it’s less about the last few basis points. It’s much more about are we aligned in terms of the game plan for growing the company. And certainly in some of those companies, since we’re growing those companies, the equity story is actually very attractive, which is why we like in many cases doing the equity co-investment and putting some of our capital side-by-side with the sponsor so that we can participate in some of the upside that we’re helping to generate on the debt side. And those equity co-invests over 17 years, over $500 million deployed in our various vehicles have added two times multiple uninvested capital and 26% IRR. So that’s a nice bonus of our model.

Maxwell Fritscher: Yes, thank you. And then with a little bit more visibility and clarity into the future rate trajectory and Fed actions, have you seen any portfolio companies kind of resume normalized CapEx spending, add-on acquisitions, assuming that they had previously paused these investments?

Arthur Penn: It’s case-by-case. I don’t know that I can give you, one that kind of sticks out where someone’s proactively leaning in ahead. We just don’t, I think most of our companies just have long-term game plans that kind of stick to them and have pulled back if needed. There’s unfortunately nothing that comes to my mind that kind of sticks out as someone who’s proactively leaning into a situation where they’re kind of running ahead of it.

Operator: I will now turn the call back to Art Penn for any additional or closing remarks.

Arthur Penn: I just want to thank everybody for being on the call today. On behalf of Rick Allorto, our Chief Financial Officer, and our entire team, thank you for your interest. Looking forward to speaking to you in mid-November. Reminder that the 9/30 quarter is our 10-K, so our earnings release and call will be out a little bit later than our typical quarterly timing, but we look forward to speaking to you then. Thank you for your interest and have a great rest of the summer.

Operator: This concludes today’s call. Thank you for your participation. You may now disconnect.