PennantPark Investment Corporation (NYSE:PNNT) Q3 2024 Earnings Call Transcript

PennantPark Investment Corporation (NYSE:PNNT) Q3 2024 Earnings Call Transcript August 8, 2024

Operator: Good afternoon, and welcome to the PennantPark Investment Corporation’s Third Fiscal Quarter 2024 Earnings Conference Call. Today’s conference is being recorded. [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 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.

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 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.

Art Penn: Thanks, Rick. We’re going to spend a few minutes and comment on the current market environment for private middle market credit, 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, our GAAP net investment income was $0.24 per share and our core net investment income was $0.21 per share. GAAP and adjusted NAV decreased 2.2% to $7.52 per share from $7.69 per share. The decrease in NAV for the quarter was due primarily to valuation adjustments on the nonaccrual loans partially offset by increases in several equity investments. As of June 30, our portfolio totaled $1.2 billion.

During the quarter, we continue to originate attractive investment opportunities and invested $163 million and 11 new and 42 existing portfolio companies at a weighted average yield of 12%. 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 3.4x, the weighted average interest coverage was 1.9x, and the weighted average loan to value was 50%. As of June 30, the portfolio’s weighted average to leverage ratio through our debt security was 4.3x and the portfolio’s weighted average interest coverage was 2x. These attractive credit statistics are a testament to our selectivity, conservative orientation and our focus on the core middle market. During 2024, the market yield on first lien term loans has tightened 50 to 75 basis points.

As the credit statistics just highlight 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 and the core middle market, we’re still getting meaningful covenant protections. At June 30, the JV portfolio equaled $926 million. During the quarter, the JV invested $56 million, including $38 million of purchases from PNNT. During the quarter, the JV made a special dividend of $4.2 million and PNNT share was $2.5 million. The dividend was the distribution of the JV’s cumulative undistributed net investment income, the special dividend is another indicator of the earnings power of the JV.

With its current capital base, the JV portfolio can grow to $1.1 billion. We’re having discussions with our JV partner to potentially grow the JV. Over the last 12 months, PNNT earned a 19.5% return on invested capital in the joint venture. We expect that with continued growth in the JV portfolio, the JV investment will enhance PNNT’s earnings momentum in future quarters. Credit quality remained strong. We had 3 non-accruals as of June 30. Non-accruals represented 4.2% of the portfolio cost and 2.5% at market value. Now let me turn to the current 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 to our borrowers.

We have a long-term track record of generating value by successfully financing growing companies — growing middle market companies in 5 key sectors. These are sectors where we have substantial domain expertise, have the right questions to ask and have an excellent track record. There 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 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 packaging 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 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 of the upper middle market, virtually all of our originated first lien loans have meaningful covenants to help protect our capital. This is a significant reason why we believe we’re 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 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 at a lower default rate and higher recovery rate than loans with the 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, which fuels the growth of our portfolio companies. In many cases, we participated 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, have generated an IRR of 26% and have generated a multiple un-invested capital of 2x.

Since inception, nearly 17 years ago, PNNT has invested $8.2 billion at an average yield of 11.3% and has experienced a loss ratio on invested capital of about 20 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 on our target market are attractive. Our experienced and talented team in 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 with a high free cash flow conversion, we capture that free cash flow primarily in 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 June 30, GAAP net investment income was $0.24 per share and core net investment income was $0.21 per share. During the quarter, we received a special dividend of $2.5 million or $0.03 per share from the JV, which consisted of cumulative undistributed net investment income from prior periods. Given the nonrecurring nature of this dividend, we have excluded it from our core net investment income. Operating expenses for the quarter were as follows: interest and credit facility expenses were $11.5 million, base management and incentive fees were $7.5 million, general and administrative expenses were $1.5 million and provision for excise taxes was $0.7 million. For the quarter ended June 30, net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $12 million.

As of June 30, our GAAP and adjusted NAV was $7.52 per share, which is down 2.2% from $7.69 per share in the prior quarter. As of June 30, our debt-to-equity ratio was 1.5x, 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 144 companies across 30 different industries. The weighted average yield on our debt investments was 12.7%. We had 3 nonaccruals, which represents 4.2% of the portfolio at cost and 2.5% at market value. The portfolio is comprised of 56% first lien secured debt, 5% second lien secured debt, 10% subordinated notes to PSLF, 4% other subordinated debt, 6% equity in PSLF, and 19% in other preferred and common equity.

96% of the debt portfolio is floating rate. Debt-to-EBITDA on the portfolio is 4.3x and interest coverage ratio is 2.0x. 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.

Q&A Session

Operator: [Operator Instructions] We’ll take our first question from Mark Hughes with Truist.

Mark Hughes: The return potential, you described very good, the 19.5% return on invested capital in the JV. If you increase the size of that as apparently you’re discussing, what’s the — how does that change the return profile? And is that level of return sustainable?

Art Penn: Mark, it’s Art. Good question. Look, we — certainly, the returns of these vehicles, the BDC itself for the JV are high now. We’ve been in a high interest rate environment. So I would say to the extent that interest rates start to come down, yields will come down across the platform in the BDC as well as the JV. Today, we’ve had a really good credit performance in that JV. There’s never an assurance that we’ll continue that. But we’re very pleased with the upper teens. I think if you want to model it, you can certainly be modeling it into the upper teens. And to the extent we finalize the arrangement to upsize the JV, whatever capital PNNT puts in, you can certainly model it in an attractive return on that capital, which should certainly be accretive to PNNT.

Mark Hughes: And then the dividend trajectory, you had a special dividend this quarter, obviously, refresh me on how that has trended over time, what the usual pacing has been on those sorts of dividends.

Art Penn: Yes. I mean, Rick is going to get you the historical — I mean, usually, we take whatever the NII for the JV is. We pay out the majority of it, and we leave a little cushion and that cushion accumulates over time. We paid out this amount, which is about $0.03 a share because we wanted to pay out all the undistributed income as we look to potentially upsize the JV. So everyone kind of come in kind of with a fresh slate. Rick, historically?

Rick Allorto: Yes. So Mark, the — I’ll say, kind of the regular kind of core dividend from the JV is about $4.8 million in the quarter.

Mark Hughes: Yes, yes. And then the equity co-invest, is that something where you might think about either increasing or decreasing the pacing, as your experience recently been kind of more or less favorable in historical terms? And does that influence your appetite on a go-forward basis?

Art Penn: That’s a great question. For us, it’s usually less macro and more micro. We’re looking at the particular companies, the investments, the entry multiples, the growth parameters, prototypical deals for us, we’re starting out with a company that’s doing $10 million to $20 million of EBITDA. The sponsor has growth trajectory in mind. There’s a delayed draw term loan. We’re helping fuel that growth. So the goal is to take that $10 million to $20 million EBITDA company growth to $30 million, $40 million, $50 million and above with our debt capital being a driver of that. So in many cases, it makes some sense for us to participate in some of that equity by co-investing side-by-side with the sponsor. These are not intended to be large equity bets intended to just be a kind of relatively small amount, but over the course of time, 5% to 10% to maybe 15% of the portfolio.

Operator: We’ll take our next question from Robert Dodd with Raymond James.

Robert Dodd: First one, I may have missed this. There’s been a lot of color. On the JV, you just to mark it, are you paying out the excess so that as it gets upside, everybody come in on the same kind of level, so can I read into that, there’s the intent to maybe not just upsize it with the existing partner, but is there an intent to maybe expand the number of partners that are involved in that JV.

Art Penn: Yes, that’s a good question. It’s working really well with our existing JV partner. It’s been great simpatico. We started with them kind of right after COVID. So kind of — it’s been — we’re kind of 3, 4-years old. I think if we had another third-party, we probably just set up a separate JV — just you start to get more different deciders around the table, make it more complex and each JV partner has their own way of thinking about things, et cetera. So I think we’re open to another JV over time if we can find the right partner who sees credit the way that we see it and sees the world the way that we see it. So I think that’s something to — that’s certainly potentially on the table for PNNT.

Robert Dodd: Got it. Just on the market outlook, right, I mean in terms of pipeline demand, Art, do you expect the recent volatility in the market very short term. So who knows how it’s going to add, to affect demand in your area of the market. I mean, yes, there’s been some BSLs pulled in the very large market, but that’s not the area you’re typically competing in. And so is it — do you expect if the volatility does persist that it would affect sponsor activity in your segment? Or any thoughts on how all that is picking up.

Art Penn: Yes. When you look going back over many years, and we’ve been at PennantPark now 17 years of business, when you have market shocks, it takes a little while for the core middle market to impact first, obviously, the broadly syndicated loan market has an impact fairly immediately, which then gets articulated to the upper middle market which then gets articulated to the core middle market where we sit. So typically, it takes up to 6 months of a choppy market before it impacts — starts to impact our market. What are we supposed to do in the meantime? We could wait. We’ve got — we’re never in a rush to invest. We’ve learned lessons over the years, you should never been — here, you never should be in a rush to invest.

So we’re never in a rush to invest. On the other side, when you find great companies and great capital stacks, it’s always a good time to invest because we feel like great companies, great situations end up working out no matter what the scenario is. So I think if this choppiness continues, we certainly are going to be thinking about the macro and seeing what’s going on, but we’re also going to be, as always, looking at the micro and trying to find excellent companies that we can back and support excellent sponsors and try to work both sides against the middle. I don’t know if that makes sense or that you understand what I’m saying.

Robert Dodd: Yes, I think I get the general idea. Again, on the non-accrual or new non-accruals, but there was a new non-accrual last quarter, Flock has been restructured the debt back on accrual in 1 quarter. You had another new non-accrual this quarter. I mean is this a similar kind of thing where it’s going to be very short term and a quick restructuring or can you give us any color on what you expect kind of the timeline this time versus last quarter.

Art Penn: Yes. Yes, Flock, that was a restructuring. We converted debt to equity. We put more money into it. We now control the company. This company is the new nonaccrual it’s called Pragmatic. They provide corporate training solutions to product managers, in many cases, technology and other industries. The sponsor injected equity underneath us. So this is a little bit different. The sponsor injected equity underneath us, we are not in control at this point. The valuation came in, in the low 60s, and it’s a PIK instrument. So given the valuation came in the low 60s and it’s PIK, we decided ourselves to put it on nonaccrual.

Operator: We’ll take our next question from Paul Johnson with KBW.

Paul Johnson: You guys seem to be approaching kind of max leverage on the balance sheet and on the BDC and also JV at least kind of the informal sort of market side, I think you had mentioned on previous calls for the JV. I know you’re obviously, potentially in discussions to expand that as well. But can you just kind of talk about your investment capacity here as we sit at kind of 1.5x leverage, should we kind of see — expecting to kind of pullback here a little bit and focus on just recycling capital at this point?

Art Penn: Yes. Paul, that’s a great question. I think that’s a fair statement, which is we’re full leverage now. We’re going to use the JV to deleverage. That’s the first thing we’re going to do. And then over time, we do expect and hope to get some rotation on the equity portfolio. M&A is starting to pick up again. There are some really interesting equity positions in there. So we’re very hopeful that we can rotate some of the equity, which will create dry powder to invest in cash-paying debt securities.

Paul Johnson: And then I realize, I mean, the portfolio overall hasn’t experienced a ton of spread compression. But I mean, within the JV, have you seen any spread compression there? I mean should we be kind of tempering expectations for kind of these additional special dividends and maybe the overall return on JVs. Are you seeing spread compressions at all?

Art Penn: Yes. I mean, look, it’s been a great time to be in the lending business, particularly if you could select good companies that pay you back, right? So we’ve got a really good track record. In general, we’ve got a really good track record in the JV. Obviously, when you have assets that are primarily floating rate and their spread compression and yields start coming down. For sure, yields and returns are going to come down in the space. What I can tell you is on the liability side, we’ve seen spread compression also. If you were on the call or listened into our earlier call in PFLT. PFLT just recently did a securitization CLO financing. And we got 50 basis points of compression on the liability side in that recent securitization.

So if you see it on the asset side, in some way, share perform, you’re going to see it on the liability side sometimes sooner, sometimes later. Our credit facility, we also redid in PFLT. Again, we did it at a tighter spread. So it may take a little while for it to — you’re never fully 100% matched. But if asset spreads are coming down, liability spreads are coming down as well.

Paul Johnson: And then one more on the JV. What level or, if any, you have loans within the JV, the structure allows and then kind of what percent of, if any, is in the JV.

Art Penn: Yes, it’s very small. We don’t have it — I don’t — I don’t think we have it in hand here. We can certainly call you back, but our level of PIK is very low in the JV. We’ve had in the nearly 4 years, we’ve had one nonaccrual in the JV to date, Dynata Research now. So it’s been — I think it’s very, very clean, but we can call you back or I can call you back later, but it’s a very low number in terms of PIK.

Operator: We’ll take our next question from Melissa Wedel with JPMorgan.

Melissa Wedel: Art, you touched on my first one. I know that equity rotation has been a long-term pull, at least for part of the allocation there. You mentioned it just now that remains part of the strategy. Given the sort of general sentiment around expecting a pickup in deal activity in the second half and as rates come down, you didn’t mention it earlier, but I’m wondering if there are any — if you feel like part of the portfolio is particularly well positioned for that? Is there anything that we should be thinking about in terms of sort of modeling and timing and rotating part of that?

Art Penn: It’s a great question. And last thing we want to do is overpromise and under deliver, Melissa, right? So look, you’re right. We believe deal activity is going to pick up. We believe interest rates are coming down. We certainly hope and want and believe that a portion of that equity portfolio is going to rotate. Hard for us to put out an estimate or guidance on the amount and the timing other than that, that continues to be a goal of ours. And as you know, much of it is not in our control. Much of it is with the equity co-investments in particular, we’re riding side-by-side with the private equity firm.

Melissa Wedel: Yes. Okay. Understood. And then a follow-up question. I just wanted to revisit the dividend and the decision to take that up a little — a quarter or two ago. Given sort of the earnings power of the portfolio right now, given sort of the tailwind that came from the onetime dividend from PSLF this quarter, which sort of met the dividend level on a quarterly basis. How are you thinking about dividend coverage? And feeling just generally about the earnings power of the portfolio given the potential for really a lower rate environment as we go forward. And I keep in mind everything you just said about expanding the JV.

Art Penn: Yes. Look, it’s a great question. We’re trying to kind of balanced earnings power of the portfolio, the JV, the potential upsizing of the JV and equity rotation. And we do have about $1 a share of spillover. So we got to pay that out and we want to kind of pay out judiciously over time and in a careful fashion, knowing that we’re fairly fully levered at this point. So we’re balancing all these different competing interests or different interest, I should say, in terms of paying out the spillover in terms of looking at the earnings power of the company and all the different elements of that. So kind of that really led to our decision to boost the dividend last quarter to $0.08 per month, in large part due to all of these different elements, including the very large spillover.

Operator: And at this time, there are no further questions. I’ll turn the call back to Art for any additional or closing remarks.

Art Penn: Thank you, everybody, for participating today. We really appreciate your interest in the company. A reminder that next quarter is our 10-K. So the quarterly call will be a little bit later than our normal. We’re going to be targeting mid-November for the quarterly earnings release and the quarterly call. In the meantime, wishing everybody a terrific end of summer and fall. Speak to you next quarter.

Operator: This does conclude today’s conference. We thank you for your participation.