Q2 2022 PennantPark Floating Rate Capital Ltd Earnings Call
Good morning, and welcome to the pennant Park floating rate Capital's second fiscal quarter 2022 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 question and answer session. Following the Speakers' remarks.
If you would like to ask a question at that time simply press star one on your telephone keypad. If you would like to withdraw your question Press Star two on your telephone keypad.
It is now my pleasure to turn the call over to Mr. Art, Penn Chairman and Chief Executive Officer of pennant Park floating rate capital. Mr. Penn You May begin your conference.
Okay.
Thank you and good morning, everyone I'd like to welcome you to kind of bark. What are you ready capital's second fiscal quarter of 2022 earnings conference call I'm joined today by what your child, our Chief Financial Officer, Richard Please start off by disclosing some general conference call information and included discussion about forward looking statements.
Thank you Lloyd.
To remind everyone that today's call is being recorded. Please note that this call is the property of <unk> floating rate capital and that any unauthorized broadcast of this call any form is strictly prohibited audio replay of the call will be available by using the telephone numbers.
<unk> provided in our earnings press releases as well as on our website.
I'll 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.
So take copies of our latest SEC filings. Please visit our website at <unk> dot com or call us at 212905 1000.
At this time I'd like to turn the call back to our chairman and Chief Executive Officer Pat.
Thanks, Richard I'm going to spend a few minutes discussing how we fared in the quarter ended March 31.
The portfolio is positioned for the upcoming quarters.
Our capital structure and liquidity.
The financials and then open it up for Q&A.
From an overall perspective in this area in this era of inflation rising interest rates and geopolitical risks, we believe that we're well positioned as a senior secured first lien lender focused on the United States, where the floating rates on our loans can protect against the rising inflation.
We are pleased to be lending into the core middle market.
Where we are important strategic capital with our borrowers.
Are not commoditized.
For the quarter ended March 31, our net investment income was 29 cents per share which includes one set of other nonrecurring income our credit quality remains solid.
With regard to the P. S S L J D.
CLO financing, we completed earlier this year as well as additional capital commitments from P. S. L P and Kemper JV will continue to grow.
Capital contributions from P. S. L. P are targeted to generate a 10% to 12% return.
During the quarter, we announced an increase to the amendment to the JV at $57 million, which puts it on a path to grow in JV to approximately $1 billion of that.
Overtime.
We believe that the increase in scale in the attractive orally will enhance P. F L PS earnings momentum.
Despite the market, having a relatively light overall origination volume in the quarter.
S. L. P grew modestly in the JV grew by 10% to the total size of $705 million.
Even though the overall market was choppy, we're pleased with the resilience of our neighborhood.
Yes, I believe it was down only eight cents per share and adjusted earnings.
Excluding the mark to market of our liabilities was down only two cents per share.
We have a long term track record of generating value by successfully refinancing high gross middle market companies and five key sectors.
These are sectors, where we have substantial domain expertise and 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 factors have also been resilient and tends to generate strong free cash flow.
As an aside government services and defense was approximately 15% of the portfolio inclusive of P. S. S. L I D.
This sector should be a beneficiary of the geopolitical environment.
In many cases, we are typically part of the first institutional capital and do a company or a founder entrepreneur or family selling their company to a middle market private equity firm.
In these situations. There is typically defined game plan in place with substantial equity support from the private equity firm to substantially grow the company to add on acquisitions or organic growth.
The loans that we provide are important strategic capital.
The growth that helps that $10 million to $20 million EBITDA company or the 30, 40 50 million of EBITDA or more.
Typically participate in the upside by making an equity co investment.
Our returns on these equity call investments have been excellent over time overall.
All for our platform from inception through March 31.
Our $324 million of equity call investments and generated an IRR of 27% and a multiple on invested capital of two seven times.
Because we are an important strategic lending partner the processing and packaging terms, we receive is attractive.
Many weeks to do our diligence with care.
We thoughtfully structured transactions with sensible credit.
Covenants substantial equity cushion to protect our capital attractive upfront.
Breads and an equity co investment.
Actually from a monitoring perspective, we received monthly financial statements will help us stay on top of the companies.
With regard to covenants virtually all of our originated personally loved that meaningful covenants, which help protect our capital.
This is one reason why our default rate and performance during Covid was so strong.
This sector of the market companies with 10 to 50 million of EBITDA as the core middle market.
As we just highlighted within the core middle market, we think our capital can add the most value and where we can get the strongest package of risk return is in the $10 million to $30 million of EBITDA range.
Our track record of pennant Park has been excellent for 15 years.
It took a step up and improve as we increased our focus on this portion of the market starting in 2015.
The core middle market is below the threshold and does not compete with the broadly syndicated loan market or high yield markets.
As many of you know there has been an enormous amount of capital raised by some of our large gears.
And as such they are.
First the focus on the upper middle market, which are companies with over $50 million of EBITDA.
Those upper middle market companies can typically also efficiently access the broadly syndicated loan market.
As a result in the upper middle market, our large peers need to aggressively compete with a broadly syndicated loan market and among themselves.
This results in transactions, where leverage is high covenants are light or nonexistent.
There's an upfront fees are compressed and decisions need to be made quickly.
Actually from a monetary perspective.
We received financial statements quarterly.
The argument you will hear is that bigger companies are less risky.
That is a perception that may makes some intuitive sense.
But the reality is quite different.
According to S&P loans to companies with less than $50 million of EBITDA.
Lower default rates and a higher recovery rate the loans to companies with higher EBITDA.
We believe that the meaningful covenant protections of core middle market loans more careful diligence and tighter monitoring has been an important part of this differentiated performance.
Our portfolio performance remains strong as of March 31st average debt to EBITDA on the portfolio was four seven times and the average interest coverage ratio the amount by which cash income exceeds cash interest expense was three one times.
This provides significant cushion to support stable investment income even as interest rates rise.
Statistics are among the most conservative in the direct lending industry.
As of March 31, we had only two non accruals out of 125 different names in <unk> and <unk>.
This represents only two 5% of the portfolio at cost and two 3% at market value.
Our credit quality since inception over 10 years ago has been excellent.
441 companies in which we have invested since inception, we've experienced only 15 non accruals.
Since inception, <unk> has invested over $4 8 billion.
And the average yield of 8%.
This compares to a loss ratio of only seven basis points annually.
And our target market the outlook for new loans is attractive.
With our experienced talented and growing.
I had origination funnel is producing active deal flow.
Let me now turn the call over to Richard our CFO to take us through the financial results in more detail.
Thank you a lot for the quarter ended December 31, net investment income was 29 per share, including <unk> <unk> per share of other income.
Looking at some of the expense categories management fees and performance based incentive fees totaled about $5 6 million.
Taxes general and administrative expenses totaled about 900000 and interest expense totaled about $6 7 million.
During the quarter ended December 31, net realized and unrealized change on investment with a loss of $1 8 million or <unk>.
<unk> per share net of associated tax provision.
Successful equity co investment program, we had a tax provision of $3 8 million.
Without that provision our net loss of $1 8 million would have been a gain of $2 million a positive <unk> <unk> per share.
Changes in the value of our credit facility and notes decreased NAV by <unk> <unk> per share net.
Net investment income equaled our dividend.
We sold $2 1 million shares this quarter through the aftermarket program above our NAV.
<unk> added another <unk> <unk> per share.
Consequently, <unk> went from $12 70, <unk> to $12 62 per share.
Adjusted NAV, excluding the mark to market of our liabilities was $12 41 per share down from $12 43 last quarter.
Our entire portfolio credit facility and notes are mark to market on the ASC 828, 825, our board.
Board of directors each quarter using the exit price provided by an independent valuation firm exchanges on dependent broker dealer quotations when active markets available.
In cases, where broker dealer quotes are inactive we use independent valuation firms to value the investments.
Our debt to equity ratio was one five times net debt to equity after subtracting cash was one four times.
A strong capital structure with diversified funding sources and no near term maturities.
Our portfolio remains highly diversified with 119 companies across 46 different industries.
87% is invested in first lien senior secured debt, including 14% in PSS.
1% in second lien debt and.
And 13% in equity, including 5% in PSS.
All of our debt portfolio has a weighted average yield of seven 5%.
99% of the debt portfolio is floating rate at 82% has a LIBOR floor.
The average LIBOR floor is 1% now let me turn the call back to art.
Thanks Richard.
Conclude we want to reiterate our mission.
It was a steady stable and protected dividend stream, coupled with the preservation of capital everything we do is aligned to that goal, we try to find less risky middle market companies that have high free cash flow conversion.
We capture that free cash flow, primarily in first lien senior secured instruments and.
And we pay out those contractual cash flows in the form of dividends to our shareholders.
In closing I'd like to thank our extremely calico personal for their commitment and dedication.
You all for your time today and for your.
Your investment and confidence in us that concludes our remarks at this time I would like to open up the call for questions.
Thank you if you would like to ask a question. Please signal by pressing star one on your telephone keypad.
If you are using a speaker phone. Please make sure. Your mute function is turned off to allow your signal to reach our equipment.
Again press Star one to ask a question.
We will take our first question.
From Mickey <unk> with Ladenburg.
Yes, good morning, Art, and Richard Hope you're well.
Art.
Obviously, we're experiencing macro headwinds that we haven't seen for a long time and you have a lot of experience in the credit markets. So I'd like to ask you where you see defaults heading this year and perhaps the next couple of years.
Thanks, Nikki good morning, Thank you for participating.
You were asking.
Great question, which.
It's hard to really obviously know we've been in a really terrific environment recently with extraordinarily low default.
So one would expect us to be as a as an industry or sector to be heading back to a more normalized environment. We can go through the litany of different issues that you know potentially a challenging.
Economy companies.
The direct lending industry, and we ourselves dependent market had.
Much lower default rates than either the leverage loan or high yield market, which we I think we're all trying to experience.
And hopefully knowing what to avoid and whatnot to avoid.
Pennant Park, we've had very limited defaults over 15 years, including to the GSC and global financial crisis, the industrial and energy downturn in the mid teens and most recently the pandemic, but I'd say the industry overall or the or the world overall is probably going to end up being a more normalized more normalized default.
Experience or do you think it's something like 2%, 3% a year.
I think our industry is going to be it's going to be a probably better than that because I think we've got some very talented managers in our sector.
That's that's helpful art and in terms of any.
Warning signs ahead of you know defaults, which as you mentioned they really can only go up from where we are you know what.
The reflation running as high as it is what trends are you seeing in your borrowers revenues in their pricing power and.
Perhaps more importantly, the ability to send their margins and service their debt.
Yeah. So look as we stated in the.
Comments, a few minutes ago on average our companies you're covering your interest you know kind of three times yourself.
So theres a lot of cushion in there for.
Potential rising rates and potential rising interest expense from floating rates, we and many of our peers really are focused on companies that have high EBITDA margins, which tend to indicate the company you are adding a lot of value you know they can.
Raised prices on their customers' relatively easily.
Reasonable control over their supply chains in this environment.
We're always asking the question your investment Committee. This company goes away does anybody really care.
Who really cares about this company and if so what does it mean to their margins what does it mean to their ability to raise prices what does it mean to their ability to match their costs. So I think our average EBITDA margin in the portfolio is something like 25%.
Which really indicates these are high value added companies.
Two by and large have control of their costs of course, theres going to be outliers in any portfolio, where you have over 100 games, which are which we have no way of 119 names of course theres going to be some.
Some are weaker performers who are having some some challenges but based on the numbers, we've seen by and large <unk> companies are performing very well so far.
That's really interesting and helpful Art, but my last question is just in terms of.
When we consider how steep the forward curve is for interest rates are implying that your risk free rates are going to climb very meaningfully and then we had spreads to that you know when when do you think borrowers will begin to push back I mean, we got this push and pull.
Lenders are maybe thinking about the investments in terms of.
Adequate risk adjusted returns and borrowers are looking at.
Climbing coupons.
Well, what do you think the market or the private lending market will be able to maintain spreads or are they going to give back some and look at things more on an IRR basis.
Yeah, it's hard to say I think one of the bigger things that may happen here, you know kind of enterprise value multiples have been at or near historical highs.
Many companies used to be unusual that a company would get sold for double digit EBITDA multiple 10 times EBITDA used to be very high enterprise value now that's kind of put yesterday and there's many companies that are getting bought and sold 14 times 15 times 20 times.
And you know kind of as the risk free rate goes up one would think that gravity would start to take some some will start to take hold in some of these higher.
Higher multiples would end up.
Coming down to Earth, a little bit what does that mean for us as a lender you know.
It's a good question I mean, it <unk> you know we've kind of.
Been in the mid fours debt to EBITDA for a long time you know.
We haven't really.
You know chased it.
Just constitutionally like debt to EBITDA goes above five times, we've become a little bit more skittish, we actually have more conviction. If we're going to go about five times.
So we've managed to.
To keep our focus you know.
On capital preservation, focusing on cash flow and free cash flow.
You know, we havent really been active in the <unk>.
Our software World, where its been you know it's been successful to date, but where we're still going.
Total cash flow lenders.
Part of it is we're staying in a part of the market, where you can do that where our capital is not commoditized, where we our strategic lending partner.
These growing companies, where what part of the first institutional capital.
Along with the private equity sponsor and then there is a real game plan to take that $10 million to $20 million EBITDA company and grow it in our debt capital is strategic to that.
So part of it is the place in the market, where we are where there's less competition, where our capital is not commoditized.
And where we become a real strategic partner in the in the deal and by doing that we can keep these reasonable multiples. We can get covenants, we have time to do our due diligence we get monthly financial statements.
The package remains very attractive.
I understand thanks for that for that explanation. That's it for me this morning.
Talk to you next quarter.
Thank you Mickey.
We will take our next question from Ryan Lynch with K B W.
Hey, good morning, Richard.
First question has to do with just what does the environment look like.
Far as.
Portfolio activity, our market activity in kind of that core middle market. Obviously, there is there is a lot of uncertainties.
In the marketplace today that that sponsors are looking at before.
Before they transact.
Just curious are are they.
It looked like they're able to get over those uncertainties and youre seeing capital formation and deployment, which would then create new opportunities for you or is it still.
A little bit lighter.
Seen in the past, obviously Q1 calendar Q1 was pretty light.
Curious what it looks like so far in Q2.
That's right Ryan Q1 was very light Q2 is picking up we are getting busier.
We're not 2021 was kind of an anomaly that was ridiculously busy and I think everyone was exhausted.
By the end of 2021 in some ways, even though we had a mellow 2022 so when we said I'll catch our breath a little bit.
I'd say, we're coming back to more normalized.
Levels of activity is it going to be 2019 levels.
I'd say, that's still probably the base case kind of think about 2019 in terms of activity levels.
Pre COVID-19.
I'll say, that's probably the kind of rough estimate that we ask for for 2022.
So we're busy.
We're not extraordinarily busy busy.
And again, given where we are in the ecosystem.
And a part of the first institutional capital with growth plans.
The great thing about our economy here in America and in how it operates is theres always interesting companies that are being created and there's always interesting companies, where there is the next generation of ownership and management need to need to come in and take it to the next level.
So there's always industrial logic, you know now that company will that platform company sell for 10 times EBITDA or eight times EBITDA.
That's a question with higher risk free rates are or water, what's the targeted IRR for the equity.
But theres always something going on and Theres always you know this is a dynamic economy that we're privileged that we have a front row seat.
And we're every day, we're seeing new kinds of companies and industries in and.
And we have an opportunity to learn and to see what's going on in the economy and can help be a value added capital provider.
Fuel their growth.
So there's always something going on down what we are you know kind of most of its 10% to 30 of EBITDA. So.
There's always there's always new things that we're learning and seeing an ad.
And kind of back to your question what does that actually mean in terms of origination flow I think you kind of got to think about it as 2019 type levels.
Okay.
That's helpful and makes sense.
The other question I had kind of a sort of a follow up on Ricky's question, maybe a little bit more directly are you seeing any pressure yet COVID-19.
That that you guys are negotiating today spreads on those deals are getting.
Where LIBOR sofa today and warehouse forward rates are you started seeing any pressure on those spreads yet.
Spread pressure.
Well the answer is we're not seeing a lot of movement over the last couple of months.
You know kind of we will see where the more liquid markets go for.
Broadly syndicated high yield equity and middle market does take it skew it may take a while to get to the middle market.
Most important thing for US is the end of the quality of the company the quality of the borrower.
The package of risk return that we're getting and Tfl T. Specifically, we've always valued safety over grabbing for the.
The extra yield and we're happy to get the upside through the equity co invest.
So you know.
We haven't seen much change so far in the middle market.
Middle market.
Okay understood.
And then last question I had.
In your prepared comments you gave some some good historical statistics under equity co investment program, which has been.
Very successful.
Part of your platform over the years I'm just curious.
The broader economic environment, whether that be some of the economic uncertainties that are out there or things like the trajectory of rising rates and the potential impact that has on an.
On equity valuations.
Does that affect your guys' willingness to.
So to deploy capital or how aggressive you want to be in that equity co.
Our investment program or is that purely just based on looking at a bottoms up specific individual company.
And whether that's a good business, you think TVN or not.
Yeah.
I'd say, we're more focused on an entry multiple and potential growth of the company. So we.
We may be fine lending to a company four and a half times debt to EBITDA, but are we doing.
We wanted to do that equity co invest at 15 times.
Maybe not right and it may depend on what we think the core trajectory of the company is would we be more apt to make that equity co investment at eight times sure that's an easier.
It's an easier equity co invest or are you, creating equity over time at eight times you might be buying your initial platform at a higher multiple but because the add on acquisitions are lower multiples. The overall multiple might be lower. So we are we are bottoms up approach to be mesh that in with <unk>.
With just being good old value investors and what's the value.
Look as I, just said a few minutes ago with the risk free rate rising inevitably.
Multiples may come down right extra multiples may come down and we have to model for that in our initial underwriting and assume you know.
Kind of a lower exit multiples and if it meets our threshold.
We think we're going to get a 20% IRR ourselves.
We're happy to do the call with us, but if it doesn't that's okay, well, we'll catch it on the next one.
Don't feel never want to put ourselves in position, where we feel pressure to deploy we want every investment standard.
On its own two feet.
And a relaxed fashion in our Congress forced to kind of.
Put the money out there. So I think that's one of the reasons our performance has been.
<unk> been strong over such a long period of time.
Okay. That's that's helpful color I appreciate the time this morning.
Thank you.
Yeah.
And as a reminder, if you would like to ask a question. Please press star one at this time again that is star one for questions.
We'll go to our next question from Kevin faults with JMP Securities.
Hi, Good morning Art and Richard.
First question dividend income from controlled investments was $3 9 million for the quarter.
Majority of that was dividend income from PSS L. But can you break out the other source of the dividend income there and whether those are reoccurring or onetime in nature.
What's your do you want to handle that one was that all P. SSL was there anything else in there.
No that's right, it's all from TSS L, but hopefully one 9 million.
Okay. So that with you guys or leave you guys recurring and hopefully growing.
Okay. That's good to hear and then.
Then.
Follow up question, one of your strategies to grow NII as equity portfolio irritation.
As of quarter on the equity portfolio was about eight 7% of the total portfolio can you just remind us where your long term target is for that bucket or what it is and then also general expectations for the timing of that rotation.
That has changed at all with increased market volatility.
Yeah. So you know I think equity, we kind of target to be in this portfolio up to 10% of the portfolio.
On a cost basis so.
We're well within that that's on a mark to market basis.
It's obviously, it's hard for us to ever predict exit.
Yeah. There is some government services defense in there that's a hot sector now it should be.
And that's a question in these kind of strong sectors do you do you exit now or do you wait a little bit by the mature a little bit.
So you know we are one of the few few direct lenders that.
Is highly involved in that space, it's kind of probably 15% of our overall platform.
Cross the various vehicles we have.
So you might see some continued.
Upward lift in the mark to market in those deals.
And then the question is for the sponsor we're not in control in most cases through the sponsored you sell now or do you.
Do you, let this positive trend.
Kind of go for a little while so hard to say.
You can see some clear winners in that portfolio you can just look at the cost versus the mark to market and that's a challenge that that you know owners with companies sponsors that they were using the company is doing so well do you really want to sell do you just let it ride for a little while so.
So you know I'm not giving you a real answer because we obviously don't really know when these exits are going to happen, but we're kind of well within that kind of 5% to 10% range.
And that portfolio of equity co invest.
Okay that makes sense and thanks for taking my questions.
Thank you.
Today's question and answer session. Mr. <unk> at this time I will turn the conference back to you for any additional or closing remarks.
I just want to thank everybody for being on the line today and your interest in P. F. L. T and we will talk to you next in early August after our next quarterly earnings. Thank you very much and have a great day.
Today's call. Thank you for your participation you may now disconnect.
[music].