PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q4 2024 Earnings Call Transcript

PennantPark Floating Rate Capital Ltd. (NYSE:PFLT) Q4 2024 Earnings Call Transcript November 26, 2024

Operator: 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 would like to turn the call back to our Chairman and Chief Executive Officer, Art Penn.

Art Penn: Thanks, Rick. We are going to spend a few minutes discussing the current market environment for private middle market lending, how we fared in the quarter ended September 30th, 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 30th, core net investment income was $0.32 per share. As of September 30th, our portfolio grew to $2 billion, or 20% from the prior quarter. During the quarter, we continued to originate attractive investment opportunities and invested $446 million in ten new and fifty existing portfolio companies at a weighted average yield of 11%. 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 3.4 times. The weighted average interest coverage was 2.5 times. The weighted average loan-to-value was 38%. Subsequent to quarter-end, we remained active and invested over $330 million at a weighted average yield of 10.2%. Investment volume is increasing. We have a robust pipeline, and we expect the remainder of 2024 to be active. During 2024, the market yield on first lien term 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 directly originated loans is excellent. In 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, in the core middle market, we are still getting meaningful covenant protections. As of September 30th, our debt to equity ratio was 1.35 times to one, with a target ratio of 1.5 times to one. We believe that we are 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. During the quarter, PFLT closed the refinancing and upsized a $351 million term debt securitization transaction at a weighted average spread of 1.89%, a four-year reinvestment period, and a twelve-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 3.1 times to one, which creates plenty of liquidity for the company. Additionally, during the quarter, we closed on an amendment and extension of the Truist revolving credit facility. The highlights of the amendment are an increase in total commitments to $636 million, a reduction in the rate to SOFR plus 225 basis points, which is down from SOFR plus 236 basis points, and an extension of the revolving period to 2027. We expect continued stability in NII in part due to our investment in the joint venture. As of September 30th, the JV portfolio totaled $913 million.

The JV remained active during the quarter and invested $46 million in five new and seven existing portfolio companies at a weighted average yield of 11.3%, including $45 million of assets purchased from PFLT. GAAP and adjusted NAV decreased 0.3% to $11.31 per share from $11.34 per share. The decrease in NAV for the quarter was due primarily to the write-off of fees and expenses associated with the previously noted securitization refinancing and revolving facility amendment and extension. Credit quality of the portfolio has remained strong. We did not add any new investments to non-accrual status, and non-accruals represent only 0.4% of the portfolio cost and 0.2% at market value. As of September 30th, the portfolio’s weighted average leverage ratio through our debt security was 4.1 times, and the portfolio’s weighted average interest coverage was 2.3 times.

We believe 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. 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. 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. Core middle market companies with $10 to $50 million of EBITDA are below the threshold and do 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, thoughtfully structured transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, and an 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 had 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 credit quality since inception over thirteen years ago has been excellent.

PFLT has invested $6.7 billion over five hundred companies, and we have experienced only twenty non-accruals. Since inception, PFLT’s loss ratio on invested capital is only ten basis points annually. As a provider of strategic capital, we fuel 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 30th, we have invested over $540 million in equity co-investments, have generated an IRR of 26%, and a multiple on invested capital of two times. Our experienced and talented team and our wide origination funnel are 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 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 30th, GAAP net investment income was $0.24 per share, and core net investment income was $0.32 per share. Core net investment income includes the add-back of $0.08 per share of one-time financing costs that were expensed during the quarter, net of the impact on incentive fees. Operating expenses for the quarter were as follows: interest and expense on debt were $19.3 million, base management and performance-based incentive fees, general and administrative expenses were $1.7 million, and provision for taxes was $0.2 million. For the quarter ended September 30th, net realized and unrealized change on investments, including provision for taxes, was a gain of $3.4 million.

As of September 30th, our GAAP NAV was $11.31, which is down 0.3% from $11.34 per share last quarter. Adjusted NAV excluding the mark-to-market of our liabilities was $11.31 per share, down 0.3% from $11.34 per share last quarter. As of September 30th, our debt to equity ratio was 1.35 times, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of September 30th, our key portfolio statistics were as follows: the portfolio remains highly diversified with 158 companies across 46 different industries. The weighted average yield on our debt investments was 11.5%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 2.9% of total interest income during the quarter.

We had two non-accruals, which represent 0.4% of the portfolio at cost and 0.2% at market value. The portfolio is comprised of 88% first lien senior secured debt, less than 1% in second lien debt, 3% in the equity of PSSL, and 9% in other equity. Our debt to EBITDA on the portfolio is 4.1 times, and interest coverage was 2.3 times. Now let me turn the call back to Art.

Art Penn: Thanks, Rick. In closing, I would 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. This concludes our remarks. At this time, I would like to open up the call to questions.

Operator: Thank you.

Q&A Session

Operator: If you would like to ask a question, you may signal by pressing star one on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. We will take our first question from Paul Johnson with KBW.

Paul Johnson: Yeah. Good morning. Thanks for taking my questions. Congrats on the big deployment this quarter. It is very active here for the firm. My only question, I guess, would be kind of what do you see in the current vintage that you currently find very attractive?

Paul Johnson: And, also, what are your thoughts about the upcoming vintage in terms of next year with the administration changeover and a declining rate environment?

Art Penn: Thanks, Paul. Good morning. Look, when you can originate loans that have an average debt to EBITDA of 3.4 times, average interest coverage of 2.5 times, a loan-to-value of 38%, and get 550 basis points over the risk-free rate on average, our view is you are supposed to be doing that all day long. So, as you know, we opt for safety and security over yield at PFLT. We have had some yield compression over the last year. It seems to have plateaued for now, but the credit quality that we get has been very high here in the core middle market, where there is a lot less competition. All the big players have moved up, and it just does not make sense for their business models to be lending to $10 million, $20 million, even $30 million EBITDA companies.

So, we have been taking advantage of that opportunity. We think it is a really good one. I think in terms of the outlook, as you can tell, it has been busy from an M&A standpoint in the core middle market. Hopefully, that means we can rotate some of these equity positions. We have had a very good track record with these equity co-investors, as we have said. A two times MOIC over eighteen years now. So hopefully, we can get liquid on some of these, rotate that capital into cash-paying yield. And then with the activity, the question will be with the supply-demand curve in the core middle market, can spreads widen again because of the supply? That would be our hope. Even if they do not, we are very pleased with the vintage given the credit stats I just outlined.

But we would hope that perhaps with more supply, spreads widen. In terms of the risk-free rate, that is way above our pay grade. Certainly, the market believes it is going to go down. The question will be how much. Did that answer your question, Paul?

Paul Johnson: Yeah. Yeah. Thanks for that, Art. But in this year, I am kind of talking about the current year and the current vintage. I mean, you say you are getting still meaningful covenants, but it is definitely been a tighter spread environment. So, I would guess, just asking, where has the deterioration occurred in terms of the terms that you are getting? Has it just been a little bit of spread pressure or a little bit of pressure on pricing that you have seen, or how has documentation held up? Are you getting the same covenants that you were getting last year? Is it less fees or less equity? Where has the deterioration or kind of the pressure on terms occurred?

Art Penn: Yeah. That is a good question. Certainly, in the good old days of rising interest rates and fear, we were getting 575 or 600 or even 625 over. The covenant cushions were closer to 25%. That is where you negotiate your cushion to the base case. Today, they are 30% or 35%. So, they are certainly wider than they were, but they are still there and they are still protective. If you want to go back to a dramatic example, you can go back to COVID. The fact that there were quarterly maintenance tests that these companies had to live up to, as well as the fact that we were getting monthly financial statements along the way, really brought people to the table quickly to discuss and figure out how we were going to solve problems together.

We have seen a lot of the same phenomenon here. Well, past COVID, it is really due to the loan-to-value that we are seeing because these sponsors have so much private equity capital beneath the debt. In the vast majority of the cases, if there is a problem with a covenant or any kind of liquidity problem, they are generally willing to put more equity in to solve that problem. Our non-accrual rate has remained really low here, and we are very thankful for that. One of the reasons is they have got so much capital beneath us that if it takes a little bit more capital to solve a problem, they are, by and large, willing to do that.

Paul Johnson: Thanks for that, Art. And then, this is for anyone on the team, I guess, but the decline in non-accruals this quarter. Could you just walk us through the driver of that? Was there a main restructure written off?

Art Penn: Yeah. So we had three non-accruals last quarter: Dynata, Pragmatic, and Walker Edison. Dynata restructured. Walker Edison and Pragmatic are still on non-accrual. So, same two out of three.

Paul Johnson: Okay. And then, last question. Rick, could you tell us the impact on a book value per share basis of the issuance from the ATM this quarter, if there was any?

Richard Allorto: No impact on NAV. We are issuing under the ATM either at or above NAV. The impact has been immaterial.

Paul Johnson: Got it. That is all for me.

Operator: Thank you. We will take our next question from Mark Hughes with Truist.

Mark Hughes: Yeah. Thank you. Good morning. Art, anything with the budget in the offing and a potential pressure on government spending? Anything in your portfolio that you have your eyes on that could be impacted by that?

Art Penn: It is a great question, Mark. We all wish we knew what will mean from an impact. As you know, defense government services have been a nice piece of this portfolio, steady and stable. Most of those businesses are service businesses where people walk into offices and do some form of cybersecurity technology, intelligence. It is not really building bombs and guns and bullets. But it has been steady and stable, and maybe there is cross-currency here. Certainly, the world from a geopolitical standpoint is a little messy right now. And, of course, as taxpayers, we all want an efficient government. Right? So we all want our tax dollars to be used efficiently. We will see how it all plays through in terms of the government services and defense.

Healthcare is a big piece of what we do. We have had a very good healthcare track record, much better than our peers. We know some of our peers have stumbled in healthcare. I think it is just, you know, we keep our leverage pretty reasonable and low. If you are leveraging a healthcare company four, four and a half times on a senior basis, you could get hurt, of course, but it is a lot less risky than the six times or seven times that maybe some of our peers have done. So our healthcare tracker has been good. We have selected the right companies in the right sectors. And like all taxpayers, we want efficient healthcare. So we will see. We are going to keep being conservative and keep leverage low. It can solve for a lot of ills. Not to say there will not be impacts, but we are just going to stick to that.

Mark Hughes: Okay. Appreciate that. How about your origination activity so far in the fourth quarter? It has been quite strong. How about repayments? How are you looking on a net basis?

Art Penn: Yeah. We are getting repayments. It happens, and that is good. When people pay us back, we say thank you. Sometimes, as you know, they do not. So getting repayments is all due to a more active M&A environment, which by and large is good for us. The equity co-invest should churn a little bit more, turn those to cash. We will get repayments. That is fine. We will hopefully deploy capital sensibly and conservatively. It is probably at least recently, I will estimate, given the opportunity, we have been probably making new investments two dollars out to one dollar getting repaid. That is just an off-the-cuff estimate. But that will ebb and flow.

Mark Hughes: And then the equity co-invest, are you seeing in these new originations the kind of similar opportunity, or is that going to be a relatively stable part of the strategy both in terms of opportunity and then your approach to those co-invest?

Art Penn: Yeah. It is a good question. Having now done this eighteen years at PennantPark and before that elsewhere, that opportunity is always there. It is a question of whether we take that opportunity. Sometimes we will graciously decline the opportunity. Depending on the situation, sometimes we will work hard to invest more because we like the equity. Over a long period of time, over many deals, it has worked out by and large. There are some big winners and some losers, but that is kind of the equity co-invest business. We have invested $540 million in the eighteen years at a 26% IRR and a two times MOIC, multiple on invested capital. So it has generally worked. We certainly had some zeros in there. We certainly had some that have been a lot more than two times.

Mark Hughes: Appreciate that. Thank you.

Operator: Thank you. We will take our next question from Doug Harter with UBS.

Doug Harter: Thanks. Can you give us updated thoughts as to how you are thinking about the dividend and maybe some of the puts and takes on earnings power in the coming year?

Art Penn: Sure. It is a great question. We think about it all the time, as you might imagine. Let’s, because we are credit guys, we are going to hit the downside first. That is how we think. What is the downside? The downside, of course, is interest rates. Right? Are interest rates going to continue to come down? And then credit quality. We think credit quality will remain strong. Of course, there is never any guarantee. The title of this vehicle is PennantPark Floating Rate Capital, which would imply that as interest rates rise and fall, this floating rate portfolio will take its cue from that to some extent. So certainly, potentially lowering rates, credit quality, and just highlighting that it is in the title of this vehicle, floating rate capital.

So that is the downside. On the upside, you have several different elements. We are not at target leverage yet. We are kind of at 1.3, 1.35. Our target leverage is 1.5 times. Equity co-invest rotation. You will see some window. As you go through our equity co-invest portfolio, you will see some that are marked up substantially. Those are always ripe. Those are kind of leading indicators of companies that are going to be sold. So, we hope to get some decent equity rotation here in this more robust M&A environment. And then we have this JV opportunity, which has historically been a mid-teens return on capital. So, we are looking at that and saying, should we upsize the existing JV? Should we do a new JV? The JV has been very successful both for PFLT and PNNT.

It is a nice way to take lower-risk senior assets, leverage them up a little bit more than we would on the balance sheet of the BDC, still safely though, generating mid to upper teens return on capital. And for the shareholder, we are managing more capital, and our management company is not charging a management fee on that. So those pure returns go to the bottom line of TSLT. So that has got some puts and takes. We will see where we go. And hopefully, I answered your question.

Doug Harter: I appreciate that, Art. Thank you.

Operator: Thank you. With no additional questions in queue, I would like to turn the call back over to Mr. Penn for any additional or closing remarks.

Art Penn: I just want to thank everybody for being on this call today and the Thanksgiving week. I want to let everyone know we are certainly grateful and thankful for the interest you show in PFLT and investing in the company. Wishing everybody a great holiday season. We will talk to you in February.

Operator: That will conclude today’s call. We appreciate your participation.