PennantPark Investment Corporation (PNNT) Earnings Call Transcript & Summary

Good afternoon, and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2023 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.

Good afternoon, everyone. I'd like to welcome you to PennantPark Investment Corporation's Third 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.

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.

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 June 30, how the portfolio is positioned for the upcoming quarters, a detailed review of the financials then open it up for Q&A. For the quarter ended June 30, our net investment income was $0.35 per share. Core NII was $0.22 per share and excludes $0.13 of one-time dividend income related to our equity investment in Dominion Voting. GAAP NAV increased 1.6% to $7.72 per share from $7.60 per share. The increase was driven largely by stable portfolio valuations and the dividend from Dominion. Adjusted NAV increased 3.1% to $7.67 per share from $7.44. The debt portfolio continues to benefit from the increase in base rates. As of June 30, our weighted average yield to maturity was 12.7%, which is up 12.1% last quarter and 9.3% last year. During the quarter, we continue to originate attractive investment opportunities and invested $70 million in new and existing portfolio companies at a weighted average yield of 12.6%. For the investments in new portfolio companies, the weighted average debt to EBITDA was 4.1x. The weighted average interest coverage was 2.1x and the weighted average loan to value was 36%. We continue to believe that the current vintage of middle market directly originated loans is excellent. Leverage is lower, spreads and upfront fees are higher and covenants are tighter. 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. Additional capital we are raising across the PennantPark platform will allow PNNT and the JV to capitalize on the attractive lending environment. At June 30, the JV portfolio equaled $794 million. And during the quarter, the JV invested $64 million, including $62 million of purchases from PNNT. After quarter end, the JV closed a $300 million securitization. This new financing, together with the existing committed junior capital from PNNT and Pantheon, will allow the JV portfolio to grow to over $1 billion of assets. Over the last 12 months, PNNT earned a 17% return on invested capital in the JV. We expect that with the continued growth in the JV portfolio, the JV investment will enhance PNNT's earnings momentum in future quarters. Credit quality of the portfolio continues to perform well. As of June 30, we had one non-accrual out of 129 different names at PNNT. This represents 1.1% of the portfolio at cost and 0% at market value. As a result of a stable debt portfolio and the growing net investment income, the Board of Directors has approved another increase in the quarterly dividend to $0.21 per share. This increase is the seventh consecutive increase to the quarterly dividend and represents a 5% increase from the prior quarter and a cumulative increase of 75% from January 2022. The dividend will be paid on October 2 to shareholders of record as of September 18. We are confident that with rising or stable base rates and continued strong credit performance, the increased dividend will be fully covered by core net investment income. We believe that a portion of the investment community values a monthly dividend. As a result, the Board has also decided to change the frequency of the dividend from quarterly to monthly. This change will be implemented in October. 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 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 to the company with attractive investment opportunities where we are important strategic capital to our borrowers. We have a long-term track record of generating value by successfully financing high-growth middle market companies in 5 key sectors. These are sectors where we have substantial domain expertise, know the right questions to ask and have an excellent track record. They are: Business services, consumer, government services and defense, Healthcare and software and technology. These sectors have also been recession resilient and tend to generate strong free cash flow. In our software vertical, we don't have any exposure to ARR loans. In many cases, we are typically part of the first institutional capital into a company and the loans that we provide are important strategic capital that fuel the growth and help that $10 million to $20 million EBITDA company grow to $30 million, $40 million, $50 million of EBITDA or more. We typically participate in the upside 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 $403 million in equity co-invests and have generated an IRR of 26% and a multiple on invested capital of 2.2x. Because we are an important strategic lending partner, the process and package of returns 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 cushion to protect our capital, attractive upfront fees and spreads and equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, virtually, all of our originated first lien loans had meaningful covenants, which help protect our capital. This is one reason why our default rate and performance during COVID was so strong and why we believe we are well positioned in this environment. This sector of the market, companies with $10 million to $50 million of EBITDA is the core middle market. The core middle market is below the threshold and does not compete with a broadly syndicated loan or high-yield markets. 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 companies with less than $50 million of EBITDA had a lower default rate and a higher recovery rate than loans to 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. Since inception, PNNT has invested $7.5 billion at an average yield of 11.2% and has experienced a loss ratio of approximately 20 basis points annually. This strong track record includes our energy investments, primarily subordinated debt investments made prior to the financial crisis and recently the pandemic. With regard to the outlook, our loans -- new loans in 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 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.

Thank you, Art. For the quarter ended June 30, net investment income was $0.35 per share and core net investment income was $0.22 per share. Core net investment income excludes $0.13 per share of one-time dividend income received from our equity investment in Dominion Voting, net of an increase in accrued excise taxes and incentive fees. Operating expenses for the quarter were as follows: Interest and credit facility expenses were $10.1 million; base management and incentive fees were $8.9 million; general and administrative expenses were $1.9 million; and provision for excise taxes was $1.2 million. For the quarter ended June 30, net realized and unrealized change on investments and debt, including provision for taxes, was a loss of $2 million or $0.03 per share. As of June 30, our GAAP NAV was $7.72 per share, which is up 1.6% from $7.60 per share in the prior quarter. Our adjusted NAV per share was $7.67, which is up 3.1% from the prior quarter. As of June 30, our debt-to-equity was 1.26x, 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 129 companies across 27 different industries. The weighted average yield on debt investments was 12.7%. The portfolio was invested in 55% first lien secured debt, 9% in second lien secured debt, 10% in subordinated notes to PSLF, 4% in other subordinated debt, 5% in PSLF equity and 17% in other preferred and common equity. 96% of the portfolio is floating rate. Debt to EBITDA on the portfolio is 4.8x, and the LTM interest coverage is 2.4x. The portfolio as a whole has a meaningful cushion with regard to interest coverage on a sensitivity basis for overall interest coverage to decrease to 1.0x, base rates would need to go up 200 basis points and EBITDA would need to decrease by 25%. This analysis is based upon the current run rate interest coverage, assuming a 5.5% base rate. Now let me turn the call back to Art.

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 Instructions] We'll take your first caller in the queue, that will come from Robert Dodd from Raymond James.

Congrats on the quarter. Going to your prepared remarks, the ramp in the pipeline question coming up on a lot of earnings -- could you give us any more color on kind of -- the kind of drivers there? Is it just a [ going ] out of the market, though the lower middle market has been more active than the upper in anyway? Or the types of refinancing add-ons? Any color like that? And then last, what's your confidence that those things are actually going to manifest?

Thanks, Robert. The disclaimer, of course, is M&A can be lumpy. So lots of things that can go. Middle market M&A is a key driver of what drives deal flow. So a little bit, it's kind of like being an economist or predicting the weather. We are busy, we are busy, we are looking at a lot of deals. What's going to land and what's going to land on this side of [ 9/30 ], what's going to land on the other side of [ 9/30 ]. It's hard to say. There's a lot of deal flow in the market. It's kind of though, like a tale of two cities where you have some very high-quality companies that had very good growth characteristics. Those types of companies are still attracting very fancy multiples in terms of enterprise value as well as even leverage. And that's one city. And the other city is companies that are -- do not quite have that kind of robust growth parameters or they may be viewed as a little bit more economically sensitive, those deals on the other hand, are hard to predict. There's still, in some cases, could be significant gaps between buyers and sellers. They could come together. So we've got pipeline in both of those categories. And we're fairly certain we're going to close a bunch of deals between now and year-end. But is it a very, very, very robust pipeline or a nice moderate pipeline? Who knows at this point. We're working hard, our deal teams are working hard. We get a lot of inquiry. And it's nice to have lease capital around our platform to execute that here at PNNT, the JV has, as we said, JV has some nice capital availability and JV has been doing very, very well, and we're hopeful that we can continue to do well and then ramp that JV.

Got it. I appreciate it. The second one, on portfolio companies that might be struggling a little bit more in this environment. How would you characterize this sponsor reaction to that? I mean, are they doing what you'd expect that they're stepping up and providing support or -- at the margin, do you think that the decision is getting -- are they telling you that this is getting harder for them? Or any color on that side?

Yes. So in terms of sponsor reaction, I think it's thankfully as expected. The environment like -- let's go back to the pandemic. That was a lot of turmoil there that was a shock to the system. And there, you might have seen sponsor behavior where people would just kind of write off and wash their hands from the bad deals and be willing to invest in the good deals, thankfully, in our scenario, they basically invested in and supported the company. This environment is less of a shock. It's more of a kind of slow grinding, the companies and sponsors absorbing what higher interest rates mean. So there's less volatile movement of their cash flow and because there's less volatile movement of their cash flow, they're not forced as much to make quick decisions about which companies they're going to support and which companies they're not going to support. So these decisions are being made in a slower fashion, they're generally being made in a thoughtful fashion. And by and large, we've continued to see sponsors really support their companies with additional capital. So obviously, when they're putting in additional capital makes it easier for us, makes it easier for us to give them some concessions when they're putting some money in junior to us. On the occasions that they might not putting capital junior to us, then those conversations are a little bit more challenging, and we have to, obviously be great to use shares and protect the interest of our investors and be a little harder around that. So nothing dramatic at this point. It's still kind of a slow moving -- slow moving scenario. And by and large, we're seeing sponsors put more money in.

[Operator Instructions] We'll move to your next question, Casey Alexander from Compass Point Research.

I just have one question, Art. Your deployments in the quarter, $70 million that you invested were 3 new and 43 existing portfolio companies, which is 1/3 of the portfolio. When 43 companies all do something at the same time, there must be something in common. What kind of trends are you seeing from those existing portfolio companies?

Yes. So good question, Casey. That's a combination of -- and this is where most of our activity -- at least in a slower M&A environment, most of your activity is with your existing companies. Many of them have these delayed draws, DDTLs, where they're doing add-on acquisitions. So that's a portion of it. And then also, as you know, we have revolver commitments. So the revolvers that we do have, and we try to limit them, revolvers we do have are usually priced at the same spread in some cases, higher spread than the term loan. So delayed draws, revolvers were kind of the key to the existing companies.

We'll hear next from Paul Johnson from KBW.

In the JV, how much capacity, I guess, do you kind of envision for growth there, both -- I mean, I guess, is it -- could you grow it any more than it is today? Or is it pretty much as what you like to be in terms of percentage of your portfolio?

Yes. So today, the JV is about $800 million in total assets with the junior capital coming from us and Pantheon as well as the CLO. We can get to a little bit over $1 billion. It's a big contributor to our NII. So we really like it. It is in our 30% bucket. So it is part of the 30% bucket. So kind of if it -- if it ain't broke, don't fix it. So speaking for PNNT, we'd like to continue to grow it, assuming we have room in our 30% bucket. I can't speak for Pantheon. We could use the 30% bucket. These JVs have been very good for our BDCs. We have one in PFLT, as you know, with Kemper. We have one in PNNT with Pantheon. These have been very good for the NII of the BDCs. And obviously, there's no additional management fee other than, obviously, on the junior capital. So it's very efficient from the standpoint of our shareholders. So look, we're going to look to continue to potentially grow them. The structures can be very robust. Obviously, it's all kind of very secure, lower risk, first lien senior secured debt, which you can finance safely in a number of different ways, including securitization CLO technology and that's long-term locked-in financing, generally low cost at which really helps kind of create that return on capital that's been very attractive. So, We'll continue to grow this JV. We'll continue to talk to Pantheon and we may even do other JVs down the road.

Okay. That's helpful. And those have been, obviously, very, very successful for you guys. And then just kind of turning to the market. I mean how do you kind of, I guess, observe today? I mean, it seems like activity has been picking up over the summer, are lenders holding the line in terms of just discipline on terms that we've kind of seen in the first half of this year? Or is that starting to soften up in any way?

That's a good question. As you know, the upper end of the direct lending market takes it -- where we are not, takes it's cue from the broadly syndicated loan space. The broadly syndicated loan space is starting to fall and that will create deal flow, which will create -- in the upper end, there's going to be -- the broadly syndicated loan market is competing with those folks. So on the upper end of our market, kind of the $40 million, $50 million EBITDA companies, we're starting to see some of the upper market guys kind of come into that zone and put a bit of pressure on that $40 million, $50 million EBITDA company kind of where we play, which is we say it's $10 million to $50 million, our mean, median is about $20 million to $30 million. We're not seeing any pressure yet, but we're vigilant. We're vigilant. Most important thing we can do is pick solid credits and create balance sheet capacity to take advantage of solid credits. So we still think the vintage -- [ '23, '24 ] is going to be good vintage, but we got to be -- we got to watch the space, and we got to be careful if things get out of hand as we always are. So nothing to report in our kind of core middle-market space yet, but we're watching.

We'll move next to Mark Hughes from Truist.

Any line of sight on repayments in the September quarter. How is that trending so far?

Nothing materially different, Mark, on repayments. We have them, we're happy to get when we underwrite loans, we are -- we say thank you when they pay us off, and it happens even in down markets. Even during the pandemic, certain people were paying us off. So that means kind of solid underwriting, but nothing materially different than what we've seen. We're seeing a drip of repayments. We're seeing new deals and, of course, the continued growth in the JV where we sell assets from PNNT the JV. So more of the same, but nothing meaningfully different.

When you think about the equity co-invest, the terms of those evolved overtime when you get into a challenging market or terms and conditions have been favorable for you like they have been in the last few quarters. Does that also manifest in the better terms on the equity co-invest? Or is that tend to be stable?

Well, that's a nuanced question because it's kind of like we invest side-by-side with the sponsor. So there's no real difference in the investment we are making with the sponsor. So there's not a lot of negotiation over the "terms". You can debate if the multiple makes sense? Is it really -- is it a company that's going to grow quickly or not so quickly? Or what's the downside? So I can say we've been pickier with equity co-invests over the last few quarters just because it's been a more challenging environment to evaluate the economy. And it might be one thing to say, gee we feel safe, making a loan of 4x cash flow and the sponsor is paying 10x for the company, so they're 6x beneath us as equity cushion. That's one type of question. The second question, which is -- should be a totally separate question for us, it is, do you co-invest in the equity at 10x. So of course, it's a higher bar for us to invest in the equity. Of course, we have to have greater conviction to do it. And so I think I would say we've just been a little bit more selective on that equity co-invest.

[Operator Instructions] We'll hear next from Kyle Joseph from Jefferies.

I just kind of want to given your portfolio size and industry exposure kind of want to get your sense for how the economy is doing? Anything you can provide us in terms of revenue and EBITDA growth trends and how that's changed and frankly, if companies at this point are starting to see a little reprieve from inflation really starting to abate?

Yes Thanks, Kyle. Look, based on the numbers we're getting, it would support the soft landing, it would support the soft landing scenario. There are certain areas that are soft. Certain areas are very strong. But when you look at our platform over 170 companies across the economy, it would support the soft landing. We're not seeing any areas of great stress. So kind of revenues are generally up across the platform. EBITDA is generally up. There are certain areas of weakness such as there's areas of consumer. We've talked about Walker Edison in the past, Walker Edison is a furniture company, did very well during COVID. It's reverted to the mean post-COVID and that's been a non-accrual. But by and large, it supports the soft landing theory. We say theory because as credit underwriters, as lenders, when we underwrite credit, we have to assume a recession. In a normal environment, we would say sometime during our 5-year loan, we have to model in a recession. The reality is today, we model in a recession kind of in year 1 because that's how we should be underwriting credit. We should be feeling comfortable about our loans even in recessionary environments. And even if there's a recession next year. So that's how we think about it. But we're not seeing -- and then to the earlier point about amendments -- the amendments that seem to be coming up or really just do by and large to the much higher interest cost that these companies need to bear now that the base rates went up so substantially. When you're paying 12% on the first lien debt, 12-plus percent of your first lien debt, and if you have a lot of leverage or if you have second lien or mezzanine debt, it's sucking up all the cash flow. So that's where the amendments would typically come in.

Yes. Got it. Helpful. And then, I mean, you talked about your area of focus is kind of the smaller companies, but with all the headlines on banks and potential capital requirement increases there. How would that kind of funnel in your market and is that a big opportunity for you guys?

I'm sorry, Kyle, the question again?

Sure with everything going on with regional banks. I know you guys focus on kind of...

Regional bank.

Yes, yes, yes, lower middle and smaller companies, but would there be any sort of reverberations -- and is that -- are you thinking about that as an opportunity for you guys?

Yes. I mean it should be. It's hard to say what exactly is meant at this point. I think it's too early to tell. Certainly, we did see prior to the Silicon Valley Bank turmoil many of the companies that we would finance at 4 or 5x once they got down to under 3x, regional banks who would refinance those capital structures at much lower spread to [ suffer ] than someone such as ourselves or any other direct lenders. So the regional banks would be a source of exit for us. I think it's too early to tell, but perhaps the good news and the bad news, perhaps we can hold on to some of those credits a little bit longer. When you're down -- we do have some of these where you're under 3x debt-to-EBITDA, and we're clipping 600 to 650 and the regional bank isn't there. We're happy with that loan. We're very happy with that loan. So that may be something that's more kind of direct for us.

We'll move next from Melissa Wedel from JPMorgan.

I wanted to touch on something that you mentioned earlier in the call about the pipeline where it's sort of bifurcated, it sounds like between some higher quality companies with loftier valuations and then also more economically sensitive companies. And I think you mentioned that you've got sort of pipeline in both segments there. When you think about sort of portfolio management or portfolio construction for the BDC, do you think about the optimal split between those? Or is it just sort of see what lands and they're all suitable for the BDC?

That's a great question. I mean I think that ends up coming out in the wash. Obviously, the higher quality, higher growing companies, we and maybe others are willing to put a little bit more leverage on because of the confidence level in that company's growth or the confidence level in that company's ability to weather a choppier economic environment. On the other hand, if you're less confident about the growth or you're less confident about the company's ability to handle an economic environment, you either say no, which is what we say the vast majority of the time or you say, let's structure a deal that is safe, where the leverage is low, where the covenants are sensible and really protect us or there's substantial equity cushion beneath us so that we feel comfortable that if there were a bump in the road, more times than not, sponsor would put more equity in. So that's kind of individual deal-by-deal credit underwriting. And we've learned, of course, high-quality companies usually take care of themselves. There's a whole world of credit that's made to companies that are not so lofty in quality that you can do well in. You just need to be really, really comfortable and need to look at your downside cases, need to keep leverage reasonable and covenants tight. So in the former, maybe you're a little bit more assertive about getting that equity co-invest. And in the latter, maybe you graciously decline the co-invest, you don't even ask for the co-invest. So again, you're talking about from a portfolio construction, is there a percentage or whatever. We've tended to have the vast majority of the portfolio in super high-quality companies. And that's generally how we underwrite and where we play.

Okay. Second question, I wanted to go to the dividend policy. Obviously, you mentioned having 7 straight dividend increases. I know there's been a lot of onetime income in this quarter and also the previous quarter. But when we look at sort of a run rate core NII and with base rate sort of we think peaking or looking to peak in the second half of this year. Should we start to think about the dividend policy maybe starting to stabilize a bit just to ride out any change in that base rate environment going forward?

It's a great question. And every quarter, it's a healthy discussion with our Board of Directors. And yes, it's hard for me to pound the table and say there's going to be another 7 increases in the dividend. I can't do that. I shouldn't do that and who really knows. It will take its cue from the quality of the portfolio. We'll take it's cue from base rates. It will take its cue from the earnings generated from the JV. We are tweaking the frequency to monthly starting in October really because we believe there's no hard numbers on it, but we're seeing -- we've seen in our other BDC PFLT. We believe there's a portion of the investment community that does value the monthly. So if it's a way to welcome other investors into our company, we're certainly would like to do that. We do have substantial spillover, so, we're going to take it quarter-by-quarter. We still believe there's more upside in NII through continued growth of the JV with continued rotation of the equity. We didn't spend much time today talking about equity rotation, but there's still something like 17% of the portfolio in preferred and common equity that hopefully will be rotated at some point. So we feel comfortable at 21. We feel like we've got substantial runway above and beyond that. But it's hard for me really to comment really firmly at this point. Hopefully, you can appreciate that.

And that does conclude the Q&A portion of our call today. I'd like to turn the conference back over to our host for any additional or closing comments.

Thanks, everybody. On behalf of Rick Allorto and myself want to thank you all for participating today, we are -- our next quarter is the 10-K. So we're -- we'll be out with earning's a little bit later than normal, kind of mid-November. So I look forward to talking to you all then and wishing everybody a healthy and happy rest of the summer. Thank you.

That does conclude today's teleconference. We thank you all for your participation. You may now disconnect.