PennantPark Investment Corporation (NYSE:PNNT) Q1 2024 Earnings Call Transcript

PennantPark Investment Corporation (NYSE:PNNT) Q1 2024 Earnings Call Transcript February 8, 2024

PennantPark Investment Corporation  isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Welcome to PennantPark Investment Corporations First 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 speaker’s remarks. [Operator Instructions]. It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Mr. Penn, you may begin your conference.

Art Penn: Good afternoon, everyone. I’d like to welcome you to PennantPark Investment Corporation’s first 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.

Rick 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 Investment Corporation 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 materially differ 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: Thank you, Rick. We’re going to spend a few minutes and comment on the current market environment for private credit, provide a summary of how we fared in the quarter ended December 31; how the portfolio is positioned for upcoming quarters; a detailed review of the financials; and then open it up for Q&A. For the quarter ended December 31, our GAAP and core net investment income was $0.24 per share. GAAP and adjusted NAV decreased 0.6% to $7.65 per share from $7.70 per share. As of December 31, our portfolio grew to $1.2 billion or 16% from the prior quarter. During the quarter we continued to originate attractive investment opportunities and invested $231 million and 12 new and 32 existing portfolio companies at a weighted average yield of 11.9%.

For the investments in new portfolio companies the weighted average debt to EBITDA was 3.7 times. The weighted average interest coverage was 2.4 times and the weighted average loan-to-value was 55%. Credit quality of the portfolio is stable. We had no new non-accruals in the quarter ended December 31. As of December 31, the portfolio’s weighted average leverage ratio through our debt security was 4.9 times. And despite the increase in base rates through 2023 and the portfolio’s weighted average interest coverage ratio was 2.2 times. On average, we have seen a 25 basis point tightening of first lien spreads. However, 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 covenant erosion in the upper middle market in the core middle market, we are still getting meaningful covenant protections. At December 31, the JV portfolio equaled $858 million and during the quarter, the JV invested $81 million including $8 million of purchases from PNNT. Over the last 12 months PNNT earned a 19% return on invested capital into the JV. We expect that with continued growth in the JV portfolio, the JV investment will continue to enhance PNNT’s earnings momentum in future quarters. Now let me turn to the current market environment. In an uncertain market environment, we are well-positioned as a lender focused on capital preservation in 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 for 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, health care and software and technology. These sectors have also been recession resilient and tend to generate strong free cash flow. The core middle market, which are 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 structured transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, upfront OID and equity co-investment. Additionally from a monitoring perspective we received 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 upper middle market state that those bigger companies are less risky.

That is a perception it may make some intuitive sense, but the reality is different. According to S&P loans to the companies with less than $50 million of EBITDA and 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. 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 December 31st, we’ve invested over $448 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1 times.

Since inception nearly 17 years ago, PNNT has invested $7.8 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of approximately 18 basis points annually. This strong track record includes investments of primarily subordinated debt made prior to the global financial crisis, legacy energy investments and recently the pandemic. With regard to the outlook new loans in our target markets are attractive, 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. We want to reiterate our goal to generate attractive risk-adjusted returns through income, coupled with long-term preservation of capital.

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 through debt 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.

Rick Allorto: Thank you, Art. For the quarter ended December 31, GAAP and core net investment income was $0.24 per share. Operating expenses for the quarter were as follows. Interest and credit facility expenses were $9.6 million, base management and incentive fees were $7.3 million, general and administrative expenses were $1.4 million, and provision for excise taxes were $0.4 million. For the quarter ended December 31, net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $5 million or $0.08 per share. As of December 31, our GAAP and adjusted NAV was $7.65 per share which is down 0.6% from $7.70 per share in the prior quarter. As of December 31, our debt-to-equity ratio was 1.4x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt.

As of December 31, our key portfolio statistics were as follows. Our portfolio remains highly diversified with 139 companies across 30 different industries, the weighted average yield on our debt investments was 12.6%, PIK income equaled only 3% of total investment income. We had one non-accrual, which represents 1% of the portfolio at cost and 0% at market value. The portfolio is comprised of 58% first lien secured debt, 7% second lien secured debt, 9% subordinated notes to PSLF, 4% other subordinated debt, 5% equity in PSLF, and 16% in other preferred and common equity. 96% of the debt portfolio is floating rate. And debt to EBITDA on the portfolio is 4.8 times, and interest coverage is 2.2 times. 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 PNNT and its shareholders. 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 to questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] And our first question comes from Mark Hughes of Truist.

Mark Hughes: I’ll go with the Mark Hughes part of that. Good. Good afternoon. Rick, what did you say the EBITDA coverage was on the overall portfolio?

Rick Allorto : So EBITDA was 4.8 times and the interest coverage was 2.2 times.

Mark Hughes : Yes. Thank you. And then any nuance now about the attractiveness of either subordinated debt or the preferred or common. The first lien is has obviously been attractive. But anything about the dynamic where you might see a little bit more of a preference for some of those other categories?

Art Penn: Yes. Thanks, Mark. And by the way just to clarify Mark Hughes is with Truist. And look we do invest across the capital structure. Obviously, it’s been really good to do first lien in this higher yield environment with the vintage and the good credit stats as well as classically will do equity co-invest to participate in some of the upside.. There are interesting second lien sub-debt and pref deals to look at. They just haven’t been that interesting relative to first lien recently. But we will continue to look. And if we have real conviction, we’ll potentially kind of take a look at adding some of that to the portfolio judiciously and carefully.

Mark Hughes : Thank you.

Operator: Next we go to the line of Robert Dodd with Raymond James. Please go ahead.

Robert Dodd : Hi, guys. And congratulations on the quarter. Just on the activity in the quarter, I didn’t catch this if you said in the prepared remarks. Can you give us an idea how much of that origination was really late in the quarter? Because it certainly looks like that you originated a lot interest income moved that much late did move right? So I presume a considerable portion of that was very late. But like just how much?

Art Penn: Yes. Thank you Robert. So about 40% of the origination was done in the month of December.

Robert Dodd : Got it. Thank you. And then looking — I mean as you said some of my questions have already been answered on a previous call. So some of the key sectors that you look at like business there is consumer government, et cetera, any change in relative attractiveness there? I mean in kind of the activity — the initial preliminary pipeline may be for the next — for the rest of the year. Is it concentrated in those sectors i.e., does it really mesh with your preferences? Or is how is that looking in terms of your potential opportunities by interest?

Art Penn: So, in general, look, we’ve been very active in defense and government services. We’re one of the leading lenders in that space given what’s going on geopolitically, we feel like there’s really nice tailwinds to that space. So we’ve been very active there. And for us, we’ve had a really good track record very stable steady and now potentially growing. Health care continues to be active for us. Now some of our peers have stumbled a little bit in health care. We’ve thankfully avoided some mistakes, and our way of looking at it and avoiding reimbursement risk, keeping leverage low, trying to get behind companies that are helping bring high-quality care to low cost has generally performed well from a credit standpoint.

And then business services, which is a big catch all. Business services can mean a lot of things. We’re active there. We’ve been less active in tech/software. It’s always been one of our smaller verticals. We’re — we lend against cash flow. We don’t lend against revenue and we lend reasonable levels of cash flow. So, we’ve — it’s a sector for us. It’s not one of our bigger sectors. And then consumer remains a sector for us. We’ve been a little bit more cautious there given some of the volatility around — potential volatility around the consumer. We’ve done better there when we’ve had brands that have some meaning. And we haven’t done a lot there recently, but if you look at kind of what’s worked for us and what hasn’t worked branded had meaning have worked.

So, it’s really been government services, defense, health care, and business services is kind of the big three for us.

Robert Dodd: Perfect. And on that point I mean you’d like to say business services is low white bucket so is health care. And to your point you didn’t do a lot of site position of its roll-up so things like that. So, reimbursement risk et cetera. I mean — so is the interest there? Is it the intersection between health care and government? Is it help care? I mean just you have had some successes in that area. So, I mean what’s looking particularly — maybe you don’t want to say on public call, but what’s looking narrower is in within that are looking good right now?

Arthur Penn: Yes, I mean there’s a number of different niches. It’s such a vast industry. It’s about 20% of the GDP of the United States. There’s so many different niches of care and services and synergies to be had among small or medium-sized providers and putting them together and then dealing with payers who want to get synergies around who they’re paying as well. So, we can — offline, we can go through some of the names in the portfolio but it’s a wide variety of different kinds of ways to articulate hopefully stable or growing health care niches with high free cash flow where you’re providing care at a reasonable cost that payers view as a reasonable cost. So, it’s enormous. We can certainly go to — going it offline but it’s all in there in the SOI statement of investments. and people can look and see go in Pennant and do the interpolation to the websites of these companies and see kind of the stuff we’re doing.

Robert Dodd: Got it. Got it. One last one if I can on credit. Obviously interest coverage et cetera that looks good. Obviously, there’s always going to be some marginal companies in the portfolio, but that’s always the case anyway. I mean in terms of trends? Are you seeing any emerging signs of weakness maybe not even in the portfolio but across businesses that are coming to market now? I mean it just seems everything is hanging in on a credit front-wise broadly much better than I would have thought if it’s me certainly like two years ago. So, is anything catching up to anybody yet? Or is it just everything picks along and everything is doing relatively fine?

Arthur Penn: Yes. We agree. It’s — as lenders were skeptics by nature, we presume and we underwrite assuming a recession which is how we underwrite. And if you rewind the tape to some of these calls a year or two ago, we were saying very clearly, we’re underwriting and assuming a recession that has not appeared. So again, our credits generally performing very well, because we underwrote assuming a recession. Now, we did not assume that base rates going way back. We did not assume base rates would be where they are today. So that’s that has been — there has been the surprise for us, it’s been by and large good because the yields we’re getting are excellent. If these base rates continue to persist, of course, in a portfolio of 100 or 150 names, there’s going to be some companies that over time just — it’s just too expensive for and where there’ll be amendments and things of that nature as this higher for longer trend continues.

If, when the Fed starts easing, that will give some of these companies a little bit of a break and a breather. But by definition, if these base rates persist for a while in any portfolio of this magnitude and the magnitude of our peers, there’s going to be companies peeling off and needing amendments and extensions and needing some relief, because you can’t have 100, 150 companies, all going up to the right, altogether no matter how good you are. And we think we’re pretty good. We think some of our peers are pretty good and by and large EBITDAs are growing 5% to 10% and we’re really thrilled with that. But by definition, there’s always a handful of companies that are going to need some help.

Robert Dodd: Got it. Thank you.

Operator: Next, we go to the line of Casey Alexander with Compass Point. Please go ahead.

Casey Alexander: Hi. Good afternoon. Thanks for taking my questions. And pretty simple stuff here. This one is just first maintenance. The weighted average yield dropped, if I’m correct about 40 bps quarter-over-quarter, which is actually a fair amount in this environment. Is that new weighted average impacted by the fact that you’re now carrying the government securities in the portfolio as opposed to categorizing them as cash and cash equivalents?

Art Penn: Well, I’ll take the first crack and kick it over to Rick. I mean for sure we’ve seen as we said spread compression. So the new deals there are coming in, call it 25 bps tighter from a spread compression standpoint, since we have been very active, the weighted average certainly has come down. Rick, I don’t know if you have any other commentary other than that.

Rick Allorto: I’ll just confirm that the government securities are not included in the calculation of the weighted average yield. So they are not impacting the outcome.

Casey Alexander: Okay. All right. Then secondly, I noticed in the SOI that you made a new loan of $50 million to Mid-Ocean. And if I’m not — and maybe I’m not correct, maybe — but I think, you’ve been sort of in and out and around that name for quite a while. Could you kind of walk us through your history with Mid-Ocean and what you found attractive to put a new $50 million in this quarter?

Art Penn: It’s a great question and you’re very astute at highlighting this. This is a company called JF Petroleum, which we’ve had for a while. It was originally a mezz [ph] deal, then it was a restructured deal, where we owned a chunk of equity and was restructured once again where we basically just became an equity holder. The company has seen a resurgence. There’s been some very smart add-on acquisitions that have been made. The company has come back very, very strongly and you could track the value of the equity there’s an equity piece that’s been marked up. It’s coming back strong. And the company we’ll see, I’ve learned not to overpromise Casey and you can appreciate that. The company is coming back strong. I just put it at that and we’ll see where we go.

Casey Alexander: All right. Thank you for taking my questions.

Operator: Next we go to the line of Paul Johnson with KBW. Please go ahead.

Paul Johnson: Good morning. Thanks for taking my question. I was just hoping to get a little bit more color maybe on just what drove the depreciation this quarter. Was it just broad across book? Or were there any loans in particular that were — that mainly drove that?

Arthur Penn: Yeah. So picking up to Casey’s last point, JF was up substantially. The three loans that have been marked down are Flock Financial, Walker Edison, which was a restructuring, which remains challenged and a company called Atlas Purchaser. So those were the big the three biggest declines in loans that got marked down during the quarter.

Paul Johnson: Got it. Yeah, thanks for that. I did notice Flock Financial, I did notice that was a bigger loan in your portfolio that was marked down this quarter. I was just curious if you could just kind of — maybe just tell us what that business is and what drove the weaker mark this quarter?

Arthur Penn: Yeah. It’s a specialty finance company. They are focused on busted credit card receivables, auto receivables. And they’ve had some recent stumbles. We are in there working with them to help solve the problem. It could be a really good sector. They’ve made some mistakes. And we’re in there working with the company in trying to help them grow, solve their problem and build back up.

Paul Johnson: Got it. I appreciate the color there. Two more. Just on the equity co-investment, it sounds like there could be some possible rotation there this year, which would be great. I was wondering if it’s at all possible to quantify that in any way maybe without names or if there’s even just any particular industry that maybe you would expect that it’s ripe for deals just any clues there would be helpful.

Arthur Penn: Yeah. So we had — in the quarter ended December we had a company called TBC gets sold and we had some equity in that. This quarter so far year-to-date, we just had an exit company got sold. I can’t tell you the name but obviously it will be public in May when we talk in May. So we’re starting to see starting to see as M&A hopefully gets back going again good news and bad news, we will inevitably get repayments of some of our better deals that’s both — that is good news and bad news at the same time. And then as we’ve said, equity co-investment is typically part of the package in many of these we will get liquid on some equity pieces, nothing that major or material but twos and threes and fives can all add up over time and they’re very helpful.

And as we’ve said our MOICs have been multiple on invested capital been north of two times historically. And both TBC and the one I’m referring to were kind of in the three to four times MOIC zone. So kind of we’ll see. It’s – you can’t count on it but as deal flow grows we hope to see some more equity rotation.

Paul Johnson: Got it. Thanks for that, Art. And last one, I’m just wondering if you guys have any sort of idea within the portfolio? I mean if you’ve seen trends of higher PIK utilization from your sponsors or even if you have any idea if that’s the case if you’re seeing higher PIK utilization what sort of percent of your loans might be on PIK at the moment? I would just assume obviously with base rates where they’re at expected to stay high for – even for – into the rest of the year that could be something we would see. But just curious to get your thoughts on that.

Art Penn: Rick do you want to talk about PIK income?

Rick Allorto: Yes. Paul for the quarter, PIK income was about 3% of total income. So currently it’s at a relatively low percentage.

Art Penn: Outlook – from an outlook standpoint, Paul look as we said if this higher for a longer trend continues inevitably, some companies are going to need some relief. And part of amendment structures could be picked. So 3% feels really good now and we’re very proud of that. But we’ll just see how long is higher for longer trend continues and quite possibly it could go higher than 3%.

Paul Johnson: Thanks. That’s all for me. Appreciate the answer today.

Rick Allorto: Thank you.

Operator: We go next to Brian McKenna with Citizens JMP. Please go ahead.

Brian McKenna: Okay. Great. Most of my questions have been asked but I just had one question for you. So we’ve seen some consolidation in the public BDC universe. And I think really what some of these consolidation announcements are getting at are greater scale and bigger kind of public vehicles. So would you ever look to merge PNNT with PFLT just to kind of create a bigger publicly traded vehicle? And if that’s something you would look at? I mean what would kind of have to take place or aligned for that to take place?

Art Penn: Yes. Thank you. So look we – all things are always on the table. So let me just state that. We’re always looking for ways to enhance shareholder value. Over time PNNT has had a different investment orientation, a little bit lower in the capital stack a little bit higher return. In addition, PNNT as we know has had a chunkier, lumpier performance and NAV. So – and it’s not traded as well quite frankly is PFLT, PFLT has had, what we think is a fairly pristine track record. So it’s something we look at from time to time. We are always looking to say “Hey, does it make sense to have two different strategies.” Does it make sense to have two different strategies? As PNNT hopefully gets less lumpy and hopefully trades better then that discussion might be something kind of more current. But it’s something we look at, something we evaluate and it’s a good question.

Brian McKenna: Helpful. Thank you.

Operator: We go next to Melissa Wedel with JPMorgan. Please go ahead.

Melissa Wedel: Good afternoon. Thanks for taking my questions. Mine have also been mostly asked already, but I thought I’d touch on portfolio leverage. Certainly, with a really productive December quarter in terms of originations, it seems like portfolio leverage has risen above where you identified your target as being. Is this — are you comfortable at current levels? Or would you consider sort of rotating out of the government securities and take a large down a bit towards your target?

Art Penn: Yeah. So, there’s a couple of different things in your question. First, the JV, kind of the way the JV works is we usually season assets at the BDC level at PNNT. And then after the season, they may move on to the JV. So December 31, was a moment in time. It was a moment in time. So our goal is really to kind of get down to kind of our core target, which is around the zone of 1.25 times. So 1.4 times, we’re a little higher than that. So we’re going to look to get back down to our target as assets move from the BDC level to the JV over time. Rick, do you want to cover the treasuries, the government securities and what we do and how we do it, so just to clarify?

Rick Allorto: Sure. So at quarter end, we are executing and putting on balance sheet some US treasuries, just from a perspective of kind of balance sheet optimization in terms of kind of how we think about utilizing kind of that 30% bad asset bucket.

Art Penn: We don’t call the bad asset bucket. We say, it’s a good asset bucket. But it’s the 30% asset bucket, opportunistic bucket. So our JV — just to be clear, our JV has been really successful. It’s been really accretive for PNNT shareholders. And we like — that’s part of our 30% bucket. And we like having room in that. We might grow the JV, we might do another JV. Keeps a very good option for the company open to optimize that 30% bucket.

Melissa Wedel: Okay. That’s helpful. I appreciate it. Separate question, it seemed like there was a lot of activity both to new companies and existing companies in the December quarter. I was just curious, if you’re — what you’re seeing in terms of sort of existing companies and how they’re using proceeds of incremental borrowings. Any trends — anything worth noting?

Art Penn: Yeah. Look, it’s — a lot of what we do is start off with companies as a platform in a particular sector where the private equity sponsor says, hey, this is our platform company. We’re going to go execute a strategy of doing add-on acquisitions. And we finance them either with delayed draws or just add-ons and incrementals. And it’s part of our normal flow. Again, this is where our equity co-invest can be helpful where we’re helping them grow the platform, and we can participate in the upside. So, nothing really dramatic. It just we were active in that calendar Q4, and that activity included existing portfolio of companies.

Melissa Wedel: Okay. So that was companies drawing down on existing facilities or you’re seeing some incremental add-on acquisition?

Art Penn: Well, in most cases there’s a delayed draw term loan that’s structured at the beginning of a deal. And that delay draw is meant to be relatively easy for the borrower to access to do add-on acquisitions or grow subject to certain thresholds. So, much of that is delay draw delay draw term loan facilities being drawn. Occasionally, it’s an incremental that’s not as delayed draw but much of it is a delay draw that’s being drawn.

Melissa Wedel: Got it. Thanks Art.

Operator: And we have no further questions. I’d like to turn the floor back to Mr. Art Penn for any additional or closing remarks.

Art Penn: Thanks everybody for being on the call today. We look forward to speaking to you next in May. Have a great day.

Operator: This concludes today’s conference. We thank you for your participation. You may disconnect your lines at this time.