PennantPark Investment Corporation (NYSE:PNNT) Q4 2023 Earnings Call Transcript

PennantPark Investment Corporation (NYSE:PNNT) Q4 2023 Earnings Call Transcript November 16, 2023

Operator: Good afternoon and welcome to PennantPark Investment Corporations 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 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 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.

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: Thanks, 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 September 30; how the portfolio is positioned for upcoming quarters; a detailed review of the financials; then open it up for Q&A. For the quarter ended September 30, our GAAP and core net investment income was $0.24 per share. Adjusted NAV increased 0.4% to $7.70 per share from $7.67 per share. GAAP NAV decreased slightly to $7.70 per share from $7.72 per share. The debt portfolio continues to benefit from the current base rate environment. As of September 30, our weighted average yield to maturity was 13%, which is up from 12.7% last quarter and 10.8% last year.

During the quarter, we continue to originate attractive investment opportunities and invested 61 million in two new and 31 existing portfolio companies at a weighted average yield of 11.2%. For the investments in new portfolio companies, the weighted average debt to EBITDA was 4.4x, the weighted average interest coverage was 1.9x, and the weighted average loan to value was 36%. 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 5x and despite the steep increase in base rates over the past 12 months, the portfolio’s weighted average interest coverage ratio at September 30 was 2.3x. We continue to believe that the current [indiscernible] core middle market directly originated loans is excellent.

Leverage is lower, spreads and 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 have continued to be active from September 30 through November 10, we invested $131 million into new and existing investments and are continuing to see strong deal flow going into year-end. At September 30, the JV portfolio equaled $804 million and during the quarter, the JV invested $57 million, including $48 million of purchases from PNNT.

During the quarter, the JV closed on the $300 million securitization. This new financing, together with the existing committed junior capital from PNNT and our JV partner will allow the JV portfolio to grow to over $1 billion of assets. Over the past 12 months, PNNT earned a 17.2% return on invested capital in the JV. We expect that with continued growth in the JV portfolio, the JV investment will enhance PNNT’s earnings momentum in future quarters. Now let me turn to the current market environment. From an overall perspective, in this market environment of inflation, rising interest rates, geopolitical risk and a potentially weakening economy, we are well positioned as a lender focused on capital preservation in the United States where the floating interest rates on our loans can protect 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 5 key sectors. These are sectors where we have substantial domain expertise and now the right questions to ask and have an excellent track record. They are business services, consumer, government services and defense, health care and software technology. These sectors have also been recession resilient and tend to generate strong free cash flow. Approximately 12% of our portfolio is in government services and defense, which is a 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, which is companies with $10 million to $50 million of EBITDA is below the threshold and does not compete with a 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 that 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 upfront OID and 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 in the upper middle market, virtually all of our originated first lien loans had meaningful covenants, which help protect our capital. If there’s 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 states that those bigger companies are less risky. That is a perception and 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 the companies with higher EBITDA. We believe that the meaningful covenant protections of the core middle market where there’s 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 also 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 2.2x. Since inception, PNNT has invested $7.6 billion at an average yield of 11.3% and has experienced a loss ratio of approximately 20 basis points annually. This strong track record includes our energy investments which were primarily, and primarily subordinated debt investments made prior to the financial crisis and recently, the pandemic.

With regard to the outlook, new loans and our target market are attractive, and this vintage should be particularly 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 investments, 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 September 30, 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 million. base management and incentive fees were $7.2 million, general and administrative expenses were $1.6 million; and provision for excise tax was $0.7 million. For the quarter ended September 30, net realized and unrealized change on investments and debt, including provision for taxes was a loss of $2.5 million or $0.04 per share. As of September 30, our GAAP NAV was $7.70 per share, which is down 0.3% from $7.72 per share in the prior quarter. Our adjusted NAV per share was $7.70, which is up 0.4% from the prior quarter.

As of September 30, our debt-to-equity ratio was 1.05x and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. As of September 30, our key portfolio statistics were as follows; our portfolio remains highly diversified with 129 companies across 27 different industries, the weighted average yield on our debt investments was 13%, we had one nonaccrual, which represents 1.2% of the portfolio at cost and 0% at market value, the portfolio is comprised of 53% first lien secured debt, 8% second lien secured debt, 10% subordinated notes to PSLF, 5% other subordinated debt, 6% equity in PSLF and 18% in other preferred and common equity, 95% of the debt portfolio is floating rate. Our debt-to-EBITDA on the portfolio is 5x and interest coverage is 2.3x.

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 1x, base rates would need to go up 200 basis points and EBITDA would need to decrease by 30%. This analysis is based upon current run rate interest coverage and assumes 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 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.

Operator: [Operator Instructions] We’ll take our first question from Robert Dodd with Raymond James.

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Q&A Session

Robert Dodd: One, actually in response to Rick’s comment about the decline in EBITDA that would be necessary to get to 1x coverage. I mean, helpful but if I remember, I think last quarter, it was 25%. This quarter, it would have to decline 30%. So can we read into that the EBITDA growth kind of year-over-year or since last quarter, the trailing EBITDA is up 5%. I mean that seems quite a lot over the course of just a quarter, but that does sound like the [acquired] [ph] deterioration now is meaningfully more than it was a quarter ago. Hope that makes sense. If you could elaborate?

Art Penn: Yes. Thanks, Robert. Thanks for the question. In general, that’s right. Our EBITDA is as a general proposition and revenues in the portfolio are up a bit, and they’ve continued overall to trend positively. Obviously, we have got different deals in the portfolio with different leverage amounts and different kind of the numbers are kind of calculated fresh each quarter based on the portfolio we have at the time, but as a general proposition, you’re right, EBITDA is up.

Robert Dodd: Got it. Thank you. And then looking at the pipeline, timing issues aside, are you seeing any change in the type of deals you’re seeing, say, in early-stage pipeline versus ones that you expect that entered the pipeline 3 or 6 months ago and might be closing now. Are the early stage 1s have any different characteristics than the others?

Art Penn: I’m trying to think if there’s any material difference. I mean we have our box. Our box is our box generally, which is for our kind of high free cash flow companies, we’re willing to tolerate a certain amount of leverage usually below 5x. We’ll occasionally go above 5x if there’s really good reason to do so, either due to quick deleveraging our growth. The company has got a moat and has a real reason to be and if there’s lots of kind of equity beneath us from sponsors, we’ve done business with who we’ve known over time, we can handicap their behavior. That’s kind of our box. Now in the upper end of the core middle market, we say the core middle market is 10% to 50% of EBITDA. In the upper end in certain sectors and certain companies that are viewed as very strong there’s a little bit of competition there.

So spreads in that piece of the market may be tightening a little bit as I think players believe the economy is in better shape or the odds of a recession are lower, A. And B, odds of a dramatic increase in interest rates are probably lower as well. So market participants are kind of saying, this is kind of the zone of interest rates we have, the economy is feeling a little bit better. So on that upper end of the core middle market, we’re seeing a little bit of spread compression.

Operator: Our next question comes from Paul Johnson of KBW.

Paul Johnson: You kind of answered my question in terms of just EBITDA and growth rate trends in the portfolio that you’re seeing this year in your answer to Robert. But I guess —

Operator: Mr. Johnson, your line is still connected. Are you able to hear me? I apologize that looks he lost his audio.

Art Penn: Yes. Let’s keep going operator and hopefully he’ll come back.

Operator: Max Mosbacher Werther with Truist Securities.

Max Mosbacher: I’m calling in for Mark Hughes. Going forward, do you have any guidance of what we should expect the mix of the portfolio to be, should we expect it to stay around the current levels of like first lien as a percent of the total investment, et cetera?

Art Penn: Yes. So good question. As a general proposition, yes, it should be generally the same, although we do continue to target lower equity exposure. We have quite a few equity co-investments that are performing well that we would hope over time as deal flow comes back as M&A comes back, we hope to rotate a bunch of those equity positions into cash, which we can then put into yield instruments. And those yield instruments would be a combination of first lien secured debt, occasionally, a piece of second lien or mezz. And then the JVs, the JVs have been very good. We have the PSLF JV. It’s been generating an upper teens 17-plus percent return. Capital in there is very, very accretive to our shareholders. So looking to rotate, I think it’s about 18% of the portfolio and preferred and common equity that is not in that joint venture. We’re looking to work that down over time.

Max Mosbacher: Thank you. And do you have a figure for the percent of the portfolio that’s under 1x interest coverage?