PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q4 2023 Earnings Call Transcript

PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q4 2023 Earnings Call Transcript November 16, 2023

Operator: Good morning, and welcome to the PennantPark Floating Rate Capital’s Fourth Fiscal Quarter 2023 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 open with 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 begin your conference.

Art Penn: Thank you, and good morning, everyone. I’d like to welcome you to PennantPark Floating Rate Capital’s Fourth Fiscal Quarter 2023 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 filing 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.

Art Penn: Thanks, Rick. We’re going to spend a few minutes discussing the current market environment for middle-market lending, how we fared in the quarter ended September 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 September 30, GAAP and core net investment income was $0.32 per share. GAAP NAV increased 1.6% to $11.13 per share from $10.96 per share. Adjusted NAV excluding the mark-to-market adjustments on our liabilities increased to $11.13 per share or 1.2%. The increase in NAV for the quarter was due primarily to positive valuation adjustments on both debt and equity investments. With a debt portfolio that is 100% floating rate, we continue to benefit from the current base rate environment.

As of September 30, our weighted average yield to maturity was 12.6%, which is up from 12.4% last quarter and 10% last year. During the quarter, we continued to originate attractive investment opportunities and invested $94 million in three new and 31 existing portfolio companies at a weighted average yield of 12.1%. For the investments in new portfolio companies, the weighted average debt to EBITDA was 3.6 times, the weighted average interest coverage was 2.3 times, and the weighted average loan to value was 36%. We continue to believe that the current vintage of core middle market directly originated loans is excellent. Leverage is lower, spreads and upfront OID are higher and covenants are tighter than in the upper middle market. Despite reports of covenant erosion in the upper middle market, in the core middle market we are still getting meaningful covenant protections.

We are seeing an increase in deal flow compared to the first half of 2023 and have a growing pipeline of interesting and attractive investment opportunities. Since quarter-end, we’ve continued to be active from September 30 through November 10, we’ve invested $76 million into new and existing investments and are continuing to see strong deal flow going into year-end. As of September 30, our debt to EBITDA ratio was 0.76:1. With a target ratio of 1.5:1, we believe that we are positioned to start to drive strong growth in net investment income going forward. Additional growth in NII can be driven by our joint venture. As of September 30th, the JV portfolio totaled $786 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 $52 million into five new and eight existing portfolio companies at a weighted average yield of 12% including 37 million of assets purchased from PFLT. We believe that the increase in the scale of the JV’s balance sheet will continue to drive attractive mid-teens returns on invested capital and enhance PFLT’s earnings momentum. Our credit quality of the portfolio is stable. We had no new non-accruals in the quarter ended September 30th. As of September 30, the portfolio’s weighted average leverage ratio through our debt security was 5.1 times, and despite the steep increase in base rates over the last 12 months, the portfolio’s weighted average interest coverage ratio at September 30th was 2.1 times. From an overall perspective, in this market environment of elevated inflation, rising interest rates, geopolitical risk, and the potentially weakening economy, we like being positioned for capital preservation as a senior secured first lien lender focused on the United States, where the floating rates on our loans can protect us against rising interest rates and inflation.

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 question to ask, and have an excellent track record. They are business services, consumer, government services and defense, healthcare, and software and technology. These sectors have also been resilient and tend to generate strong free cash flow. Approximately 12% of our portfolio is in government services and defense which is the sector with strong tailwinds in this geopolitical environment.

In our software vertical, we don’t have any exposure to ARR loans. 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 upfront OID, and equity co-investment. 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 first-lien 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 broadly syndicated loan and upper middle market state that those companies are less risky, that might 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 10 years ago has been excellent. PFLT has invested $5.3 billion in 468 companies and we have experienced only 18 non-accruals. Since inception, PFLT’s loss ratio was only 15 basis points annually. As a provider of strategic capital that 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 September 30, we’ve invested over $410 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.2 times. Our experienced and talented team and 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 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 senior secured 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 September 30, GAAP and core net investment income was $0.32 per share. Operating expenses for the quarter were as follows. Interest and expenses on debt were $8.6 million, base management and performance-based incentive fees were $7.4 million, general and administrative expenses were $1.1 million and provision for taxes were $150,000. For the quarter ended September 30, net realized and unrealized change on investments including provision for taxes was a gain of $9.5 million or $0.16 per share. The unrealized appreciation on our credit facility and notes for the quarter was $2.6 million or $0.04 per share. As of September 30, our GAAP NAV was $11.13, which is up 1.6% from $10.96 per share last quarter.

Adjusted NAV excluding the mark-to-market of our liabilities was $11.13 per share, up 1.2% from $11 per share last quarter. As of September 30th, our debt-to-equity ratio was 0.76 times and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. We have sufficient liquidity in our revolving credit facility to repay the $76 million of unsecured notes maturing on December 15. As of September 30, our key portfolio statistics were as follows. Our portfolio remains highly diversified with 131 companies across 45 different industries, the weighted average yield on our debt investments was 12.6% and approximately 100% of the debt portfolio is floating rate. We had three non-accruals, which represent 1% of the portfolio at cost and 0% at fair market value.

We did not put any new investments on non-accrual during the quarter. The portfolio is comprised of 85% first lien senior secured debt, less than 1% in second lien debt, 5% in equity of PSSL, and 10% in other equity. The debt to EBITDA on the portfolio is 5.1 times and interest coverage was 2.1 times. The portfolio as a whole has a meaningful cushion with regard to interest coverage. On a sensitivity basis for the portfolio’s overall interest coverage to decrease to 1 times base rates would need to go up 200 basis points and EBITDA would need to decrease by 40%. This analysis is based upon current run rate interest coverage, assuming a 5.5% base rate. Now let me turn the call back to Art.

Art 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.

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Q&A Session

Operator: Thank you, Art. [Operator Instructions] And we’ll take our first question from Ryan Lynch from KBW. Please go ahead.

Ryan Lynch: Hey. Good morning, and thanks for taking my questions. First one I had was just on the level of repayments exits you guys have has been pretty high the last couple of quarters. Can you just talk about, is there something going on that’s really been — in the marketplace that’s really been driving the higher level of repayments or is it just a combination of, kind of normal-sized repayments and your desire to kind of drop-down some of those and exit some of those into the JV?

Art Penn: Thanks, Ryan, good morning. Yes, certainly some of those deals ended up in the JV for sure. And then I’d just say it’s normal activity. When you pick solid credits and they perform well — and most of our portfolio is performing very well, you get paid off. Our origination flow has been a little lighter up until through 9/30 we’ve been busier since 9/30 I think we’re going to be busier kind of coming into year-end and beyond. So deal flow has picked up, none of this was kind of intentional for us. We certainly can manage repayments, other than if they fit the JV. And then when we see attractive new deals come through, we clearly want to select those and we’ve been seeing more of those in the recent weeks.

Ryan Lynch: Okay. So I’d love to just touch on that last point a little bit more. Can you just talk about the deal environment? Obviously, the deals that you guys are doing you mentioned some pretty incredible stats with leverage, interest coverage, and loan-to-value on new loans as well as the spreads and absolute yields are pretty high. I know there’s certainly in the upper middle market, there’s certainly hope that the deal activity is going to pick up as private equity and buyers and sellers start to get a little more clarity with interest rates and pricing. I’d love to just hear kind of your insights on what you’re seeing in kind of the core middle market and when do you think that that would translate into a meaningful pickup in deal activity in your world.

Art Penn: Yes. So we think that activity is picking up. We’ve seen it in lifetime, which is why we’ve added the recent developments, subsequent event disclosure to the press release. And our sense is kind of it’s been sellers have been — have needed some time to adjust to the new environment. The multiples that they could get selling their companies at the end of ’21 are no longer generally available to them. So, it’s taken them a while to adjust to get their mind around it. Clearly, if you’re a buyer of one of these companies, you have to absorb higher interest rates by definition. So multiples have come down, certainly from where they were in 2021 and that’s taken some time to find its equilibrium. So that’s been the biggest part of it and I think most of — mostly the other big part of it is there is a general sense that we’re in kind of the interest rate so that we’re going to be in for a while, maybe it goes up a little bit, maybe it goes down a little bit, but in general, kind of people aren’t going to be waking up kind of and seeing much higher interest rates or much lower interest rates decisions can be made, you kind of where the base rates of 5.5% for 5.75% or 5.25% this is own people have accepted and they can therefore price that into the — to the deals that they’re trying to do.

Ryan Lynch: Okay. That’s all from me. I appreciate the time today.

Art Penn: Thank you.

Operator: Thank you. And next we’ll go to Mickey Schleien from Ladenburg. Please go ahead.

Mickey Schleien: Yes. Good morning, Art and Rick. Art, the portfolio has some exposure to what could be considered cyclical sectors like construction and consumer and auto and hotels and leisure, things like that. Can you describe how those credits are generally doing and the prospects for those credits going into next year as — with the things we’ve read in the headlines with savings rates going down and credit cards being tapped out and things like that.

Art Penn: Yeah. No, we — thank you, Mickey. We specifically try to avoid kind of cyclical names, so if something has the word construction next to it, it will be some kind of service business, typically something that’s architectural or engineering services where the underlying market is less cyclical. So if we’re in an architectural or engineering services business and won’t really be tied to homebuilding it might be tied to infrastructure spending, which has been an area of growth or might be tied to a renovation which goes on whether or not people have capital or not. Consumer is something we’re watching clearly. When we do consumer we’re very aware of the environment. So we specifically keep leverage lower on our consumer deals than we do on our average deals and we typically try to find companies that have brands that have value and meaning in their marketplace.

So Dr. Scholl’s as an example, it’s a big brand, it’s a branded consumer company, leverage is reasonable on it. People are aware of the brand, so kind of RTIC, which is a YETI (ph) comparable, it’s a lower cost version of YETI in our portfolio. When we did the deal, leverage was very low, and because it’s a lower-cost version, it’s actually doing pretty well in this kind of environment. So that’s kind of how we think about consumer, that’s how we kind of think about construction, I’m happy to dive deeper if you like.