PennantPark Floating Rate Capital Ltd
NASDAQ:PFLT
Earnings Call Analysis
Q1-2024 Analysis
PennantPark Floating Rate Capital Ltd
The company reported a GAAP and core net investment income of $0.33 per share for the quarter ended December 31. This performance, coupled with a 0.6% increase in GAAP and adjusted Net Asset Value (NAV) to $11.20 from $11.13 per share, underscores a period of stable profitability and marginal asset value appreciation for the investors.
During the quarter, $303 million was deployed into 13 new and 34 existing portfolio companies at a weighted average yield of 11.9%. These investments represent attractive opportunities and highlight the company's commitment to capital deployment in pursuit of yield-generating assets.
The company's weighted average debt to EBITDA stood at 3.8x, with a debt-to-equity ratio of 1.02:1, suggesting prudent leverage management. A targeted ratio of 1.5:1 indicates potential for future growth without compromising financial health.
The credit quality within the portfolio remained stable, exemplifying no new nonaccruals for the quarter and a weighted average interest coverage ratio of 2.1x. This indicates a solid interest payment capacity despite an uptick in base rates throughout 2023.
The company maintains a diversified investment focus with approximately 12% of the portfolio in government services and defense, a sector benefiting from current geopolitical dynamics and known for generating strong free cash flow.
Over the past 13 years, the company's track record reflects exceptional credit quality, with investments totaling $5.6 billion across 481 companies and experiencing only 18 nonaccruals, resulting in a minimal loss ratio on invested capital of just 13 basis points annually.
The joint venture (JV) partnership, which now holds a portfolio total of $837 million, is set to foster growth with a targeted asset size of approximately $1 billion. The JV's investment expansion, coupled with solid mid-teens returns on invested capital, is anticipated to further enhance earnings for the company and its shareholders.
With 141 companies across 33 industries in the portfolio and a weighted average yield on debt investments at 12.5%, the company exhibits a high level of diversification. Notably, all debt investments are floating rate, allowing the portfolio to potentially benefit from rising interest rates, and nonaccruals are a minor portion at 0.1% of the portfolio at cost.
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Good morning, and welcome to the PennantPark Floating Rate Capital's 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 Floating Rate Capital. Mr. Penn, you may begin your conference.
Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's First Fiscal Quarter 2024 Earnings Conference Call. I'm joined today by Rick Allorto, our Chief Financial Officer. Rick, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.
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 Floating Rate Capital 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 those 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 discussing the current market environment for middle market lending, how we fared in the quarter ended December 31, 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 December 31, GAAP and core net investment income was $0.33 per share. GAAP and adjusted NAV increased 0.6% to $11.20 per share from $11.13 per share. The increase in NAV for the quarter was due primarily to the positive valuation adjustments on both debt and equity investments. As of December 31, our portfolio grew to $1.3 billion or 19% from the prior quarter.
During the quarter, we continue to originate attractive investment opportunities and invested $303 million in 13 new and 34 existing portfolio companies at a weighted average yield of 11.9%. For the investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.8x. The weighted average interest coverage was 2.4x, and the weighted average loan to value was 51%. On average, we have seen a 25 basis point tightening on first lien spreads. However, we continue to believe that the current vintage of core middle market directly originated loans is excellent.
Leverage is lower, spreads in upfront OID are higher, covenants are tighter than in the upper middle market. Despite covenant erosion in the upper middle market and the core middle market, we are still getting meaningful covenant protections. Our deal flow continues to be very active. And since quarter end, we invested $103 million into new and existing investments. As of December 31, our debt-to-equity ratio was 1.02:1. With a target ratio of 1.5:1, we believe that we are well positioned to drive additional growth in net investment income going forward. We expect additional growth in NII in part to be driven by our investment in the joint venture. As of December 31, the JV portfolio totaled $837 million. And together with our JV partner, we continue to execute on the plan to grow the JV portfolio to approximately $1 billion of assets. During the quarter, the JV invested $76 million in 4 new and 9 existing portfolio companies at a weighted average yield of 12.3%, including $75 million of assets purchased from PFLT. We believe that the increase in scale of the JV's balance sheet will continue to drive attractive mid-teens returns on invested capital and enhance PFLT's earnings momentum. Credit quality of the portfolio was stable. We had no new nonaccruals in the quarter ended December 31, and we restructured 2 investments that were on nonaccrual resulting in the return to accrual status. As of December 31, the portfolio's weighted average leverage ratio through our debt security was 4.8x. And despite the steep increase in base rates during 2023, the portfolio's weighted average interest coverage ratio at December 31 was 2.1x.
In an uncertain market environment, we like being positioned for capital preservation as a senior secured first lien lender focused on 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 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, health care and software and technology. These sectors have also been 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. Our software vertical and 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 we receive is attractive. We have many weeks to do our diligence with care. We thoughtfully structured transactions with sensible credit statistics, meaningful covenants, substantial equity cushions to protect our capital, attractive spreads, upfront OID and equity co-investment. Additionally, from a monitoring perspective, we received monthly financial statements to help us stay on top of the companies.
With regard to covenants, unlike the erosion in the upper middle market, virtually all of our originated first lien loans had meaningful covenants, which help protect our capital. This is a significant reason why we believe we are well positioned in this environment. Many of our peers who focus on the upper middle market state that those bigger companies are less risky. That 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 a higher recovery rate than loans to companies with higher EBITDA. We believe that the meaningful covenant protections of core middle market loans, more careful diligence and tighter monitoring has been an important part of this differentiated performance.
Our credit quality since inception over 13 years ago has been excellent. PFLT has invested $5.6 billion in 481 companies, and we have experienced only 18 nonaccruals. Since inception, PFLT's loss ratio on invested capital is only 13 basis points annually. As a provider of strategic capital that fuels the growth of our portfolio companies, in many cases, we participate in the upside of the company by making an equity co-investment. Our returns on these equity co-investments have been excellent over time. Overall, for our platform from inception through December 31, we've invested over $448 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2.1x.
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. Our mission and goal are a steady, stable and protected dividend stream, coupled with the preservation of capital. Everything we do is aligned to that goal. 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 in first lien senior secured 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 in more detail.
Thank you, Art. For the quarter ended December 31, GAAP and core net investment income was $0.33 per share. Operating expenses for the quarter were as follows: interest and expenses on debt were $8.9 million, base management and performance-based incentive fees were $7.8 million, general and administrative expenses were $1.6 million, and provision for taxes were $154,000.
For the quarter ended December 31, net realized and unrealized change on investments, including provision for taxes was a gain of $3.1 million or $0.05 per share. The unrealized appreciation on our credit facility and notes for the quarter was $0.1 million.
As of December 31, our GAAP NAV was $11.20 per share, which is up 0.6% from $11.13 per share last quarter. Adjusted NAV, excluding the mark-to-market of our liabilities was $11.20 per share, up 0.6% from $11.13 per share last quarter. As of December 31, our debt-to-equity ratio was 1.02x, and our capital structure is diversified across multiple funding sources, including both secured and unsecured debt. During the quarter, we used liquidity from our revolving credit facility to repay the $76 million of unsecured notes that matured on December 15. As of December 31, our key portfolio statistics were as follows: our portfolio remains highly diversified with 141 companies across 33 different industries, the weighted average yield on our debt investments was 12.5%, and approximately 100% of the debt portfolio is floating rate. PIK income equaled only 2% of total investment income for the quarter. We had one nonaccrual, which represents 0.1% of the portfolio at cost and 0% at market value. We did not put any new investments on nonaccrual during the quarter.
The portfolio is comprised of 86% first lien senior secured debt, less than 1% in second lien debt, 4% in equity of PSSL and 9% in other equity. The debt to EBITDA on the portfolio is 4.8x, and interest coverage was 2.1x. 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 PFLT and its shareholders. Thank you all for your time today and for your 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 will take our first question from Brian McKenna with JMP.
Great. So it's good to see the pickup in origination activity during the quarter. And then it seems like this momentum has carried into the new calendar year. So what's the base case expectation for investment activity looking out over the next few quarters? And then when you look at the new portfolio companies you've invested to more recently, where do the majority of these investments sit from a sector perspective?
Thanks, Brian. Just I'll answer the second one first. The sectors remain the same. We're doing quite a bit in government services and defense, which, as you might imagine, is an active sector. We're doing quite a bit in health care, in sectors of health care that we like that have strong free cash flow and that are performing. And then just to running the gamut of business services are kind of where we've been most active recently.
In terms of expectations, it's a great question. Of course, we don't really know. We do believe that 2024 will be an active year overall. Certainly, in the first calendar quarter of '24, it's been more active than normal. Usually, the first calendar quarter is light. From the standpoint of activity level, this has been more of a moderate activity for us in Q1. So kind of we do believe as -- if we're sitting here a year from now, we'll be in active with 2024, don't know what the ensuing quarters will bring.
Got it. Helpful. And then maybe just a follow-up on leverage. So that increased pretty meaningfully in the quarter, but that's from a pretty low base in the prior quarter. So sitting at about 1x today, it's still kind of at that lower end of the range. So I guess, how should we think about the trajectory of leverage from here? And then I guess, again, what scenario or deployment environment would ultimately drive leverage, notably higher from here?
Yes. So our long-term target is still about 1.5x area -- leverage for this portfolio, which is a lower risk first lien portfolio. Look, we take it as it comes. We have a nice -- in essence, war chest right now. We believe that this vintage is likely to continue to be a great vintage. We shared with you some of the credit stats and low leverage and good loan to value and high interest coverage that we're getting in this vintage.
So we're going to try to be active when we can find high-quality deals. We're still highly selective about what fits our box. As you can tell, we've refined our box over time, and we've gotten to be better and better over time, which results in kind of the low nonaccrual rate that we've been seeing and good credit stat. So when do we get to 1.5x leverage? Again, that goes back to kind of expectations around origination where the markets are, et cetera. But we feel good having this night war chest, being able to take advantage of an excellent vintage. And if we can earn these kinds of NIIs and ROEs, less levered, hopefully, there's some really nice upside for our shareholders as we judiciously deploy over time.
We will take our next question from Paul Johnson with KBW.
You sort of answered my question there, sort of on your outlook for activity, but just -- I mean, I'm curious as to given recent quarter here, what drove the higher originations. I mean was it just the attractive loans that you saw? Or was it anything due to kind of timing, things pending, et cetera? Yes, it's really all just on the -- what drove the high activity in the fourth quarter?
Yes. And it's a good question. And our business model is one where -- in many cases, we're providing that initial loan to a company that's a platform investment for private equity sponsor who sees growth opportunity typically add-on acquisitions in a particular industry or sector. So much of this was not refinancing or opportunistic financing, which is probably a lot of what you see in the upper middle market. Vast majority of this is platform deals and then the add-on investments to fuel the growth of these sectors.
So typical investment for us will start out with a company that does $20 million of EBITDA, but the goal is to get it to $40 million or $50 million or higher over time. We make our initial platform alone. And then we become their strategic partner. And you saw quite a bit of kind of add-on incremental delayed draw activity, and that's kind of -- that's a big part of what we do, and it remains.
So -- so certainly, overall M&A trends are important around here. But in many cases, this is driven by fundamental opportunity in particular sectors where our private equity sponsor partners are finding areas of opportunities. So kind of active Q4, calendar Q4, we remain active -- not as active -- we're not as active as we were in calendar Q4. We're active, but not -- I'd say we're moderately active as we speak. But that's just fine. We're not in a rush to deploy capital. We want to be careful and judicious and selective and we've learned a lesson that if you force investment, that always backfire. So we're taking a one deal at a time.
Yes. Thanks for the detail on that. That's very helpful. And then I mean, are these investments that you would expect to probably hold on to? Or are these going to find their way into the JV at some point?
Yes. So it's a good question. The JV typically kind of takes a pro rata piece to the extent it has liquidity and it does, pro rata piece of the deals that we originate. The JV has a couple of hundred million of liquidity. So over time, much of what's new will find its way into the JV, which is a highly diversified portfolio. And certainly, it's certainly been a nicely accretive vehicle for our PFLT shareholders, and we hope it continues to be so.
And then my last question was just on the large increase in equity investments this quarter, I'm just curious if there was any kind of significant investments that you guys made in the quarter that drove that? Or was that just more of a function of the higher activity in co-investments that you received during the quarter?
Yes. No, there was just really a function of the high activity. In many cases, as we say, we will co-invest in the equity. And we are starting to see, thankfully, some repayments and many of those repayments are actual exits where we hope to be rotating successful equity co-investments that we've made and there's one that just closed the other day, which is a 3x MOIC.
So we're starting to see some rotation, which is nice. But again, this will go back to kind of deal activity, kind of what's overall deal activity, is it a good time to exit or the sponsors who've been holding on, are they going to exit and take the win? Or are they going to hold on? So I'd expect as things get busier, we'll be able to rotate that equity portfolio from existing names into new names.
We will take our next question from Mickey Schleien with Ladenburg.
Art, this quarter's fee income was the highest it's been in a couple of years. Were there any outsized prepayment fees in the activity this quarter or what else could have caused that amount?
It was just a lot. There's just a lot of activity. There was 1 or 2 amendments that or bigger pieces of it, but it was not -- it wasn't the main driver, so there was just quite a bit of activity. Look, we had quite a bit of new loan activity which has been an active quarter -- active quarter overall.
Okay. And in terms of your unfunded commitments in the Q, it says it's about $270 million. What proportion of that is at the discretion of the portfolio companies?
So it's about 50-50 revolver and delayed draw, right? So the revolvers are at the company's discretion. Delayed draw -- delayed draws typically, they have to meet some kind of covenants or performance thresholds. And as -- and they have to find add-on deals. Typically, that's why they do delayed draws is because they want to consolidate a particular industry.
And as we found in times of turmoil, like COVID or even back in the GFC, although the delayed draws were less or a part of it then. In times of turmoil, as many borrowers will borrow from the revolver but the delayed draw activity will go to 0 because there's no add-on acquisitions. So if you look at the couple of hundred million that we have, it's about half and half. If there were to be any kind of COVID type or emergency scenario, the revolvers would not -- maybe not be fully drawn, but at least half drawn, but delayed draw activity would go to 0.
Okay. Fair enough. Talking about the right side of the balance sheet, Art, you're now in a position where about 3/4 of your debt liabilities are in the credit facility at floating rates. Are you comfortable leaving it that way and potentially taking advantage of declining rates later this year? Or are you looking at issuing some more unsecured debt and unlocking some of the capacity from the revolver?
Yes. I think before unsecured debt, the CLO securitization technology is a really good liability management tool, particularly for these lower-risk first lien loans. So middle market CLOs are kind of becoming a darling in the CLO market, you may know this. I know you kind of cover CLOs Mickey. And we have a very good track record of -- as a CLO, middle-market manager in our BDCs and our JVs and as well as for third-party investors.
So probably step on to create liquidity for the revolver is a securitization. And of course, we're always looking at the unsecured markets. We have a big slug of unsecured paper that doesn't mature until 2026. That's a 4 handle. So we're in no rush with yields coming down. We can be opportunistic about unsecured. It certainly is part of the tool chest, but we don't really need it right now, particularly when we can get for efficient securitization financing.
And Art, if you were to do a new securitization through a CLO structure, any sense of where that would be priced in today's market?
Yes. I mean, it would probably be low $200s million , $230-ish million.
We will take our next question from Mark Hughes with Truist.
Art, you described a pretty good interest coverage there, 2.1x, I think, for the portfolio. Can you say anything about what proportion may be closer to 1x or below? And -- any sense on how you think credit will trend over the next 6, 12 months?
Yes. So don't have it at our fingertips, the lower interest coverage. Look, there's a handful of deals. We have over 100 deal, 100 loans. I mean, there's always going to be a handful of loans that are underperforming. We have that, too. I'm going to call it, it's only a handful, which to me means around 3 to 5 to 6 that are kind of on a major watch. And they show up, if you look at the mark-to-market and the fair value, you'll be able to ascertain which ones there are.
But by and large, it's really kind of a very clean portfolio at this point. Is this going to persist? Or are things going to fray as high interest costs continue to either way, quite possibly. I mean, this has been a very benign environment, certainly for us and maybe for the market. Is it going to stay benign for the long term? Unclear. Certainly, we should assume that it's not going to be as benign as it's been, but the economy seems strong. And certainly, if and when interest rates start coming down, the Fed starts easing that will create some cushion in some of the capital structures that are a little tighter, that are kind of grinding away here kind of with tighter coverage. So right now, we're in a pretty good position. You've seen very low nonaccruals. Again, only a handful of names that are kind of more on the severe watch list, but we're staying watchful and cautious. And certainly, on the new deals that we're doing, and we shared with you that the credit stats were -- we're finding some really great lower risk, attractive return investments. And as the portfolio grows and gets populated with this vintage, some of the handful of deals that are underperforming will become even less significant in the overall scheme.
Yes, understood. And then you mentioned the covenants you think you're seeing erosion at the upper end of the market, but you're holding pretty firm that those covenants, how do they compare with what you might have seen normal course of business, say, pre-COVID, still pretty rich. Are you going to see some erosion even perhaps within your packages?
Yes. Yes, I'd say we're kind of back to kind of pre-COVID levels with reasonable cushions that protect us -- that -- and we do get the monthly financial statements. So I'd say we're back to pre-COVID. Certainly, if you look at 2022 and early '23, it was tighter. We could get tighter. I kind of -- we kind of said that spreads have come down 25%. I think in line with that, the covenants are kind of normalizing to pre-COVID.
So -- if you remember, going to COVID, we had at that point across our book, about 150 loans across our platform. And between the quarterly maintenance test that we had and have and the monthly financial statements that we get that were obligated to be shared with us, we could during COVID and did during a COVID scenario really get to the table early. Because of the quarterly maintenance tests, which many of the sponsors and companies knew that they were not going to make and because they had to share with us the monthly financial information, really got us to the table early to help be proactive and figure out how to solve problems and figure out what liquidity was needed. So we're back to the pre-COVID covenants and the information rights, which really was -- worked out very well for us in the core middle market when COVID hit. And out of the 150 deals -- loans that we had across our portfolio, just to refresh, 15 of those are about 10% actually needed cash liquidity to get through COVID. And in all of those cases, the sponsors offer to put capital in to solve the problem. So that's the benefit of monthly information rights, quarterly maintenance covenants. When we talk about the core middle market versus the upper middle market and the pluses and the minuses and -- we really like this core middle market where these protections and information rights really kind of get us to the table quick.
We will take our next question from Vilas Abraham with UBS.
I just had a question on repayments. Can you share any kind of line of sight that you have repayments, prepayments for the first half of the year? And presumably, if origination activity continues to be strong, repay should pick up as well? And just kind of talk about that and if that would be a bit of an impediment in getting to your leverage goals.
Yes. Look, we are starting to see repayments. It's not a wave. They're not -- there are certainly nowhere near being equal to our originations. But repayments indicate that M&A is -- is maybe starting to percolate a little bit. So pluses and minuses, when we get repaid, we -- we say thank you very much for repaying us because sometimes they don't. So we're very appreciative when we get repaid. And in many cases, that also means we're bringing the cash register from the equity co-investment side. So some of that is starting to happen, which we're happy with.
And as I said, we're -- we're -- we're originating new deals. Again, we don't sit here and say, "Gee, we got to get to 1.5x because the research community wants to see it happen in their model in the next 2 or 3 quarters. We try to -- and what we do is each deal has to make sense on its own 2 feet. It's a very rigorous process that we go through. We'll get there when we get there. We're healthily beating our dividend even as we speak in underlevered environment and also in an environment where JV is also not fully deployed.
So we're earning a healthy cushion to the dividend. We think the rest of this, whether it be on balance sheet leverage or the balance sheet of the JV kind of gives us a war chest to select hopefully, great deals in what should be -- what remains what we think are really good vintage. So we'll get there when we get there. We're not in a rush because we know if you're in a rush, that usually doesn't work out well. And the deal flow will come. We do think it will be 20 -- we think 2024 will be an active year.
Okay. Great. And then just my other question, just on yield and spread dynamics. It looked like -- it looks like you're Q4 average yields for new deals were 11.9%. The average portfolio is higher than that. But then quarter-to-date, deals, I think I saw around 13% on weighted average yield. So can you just kind of talk about -- it looks like a little bit of choppiness there and kind of what to expect trend-wise there in the near term?
Yes. Yes. That's a typo. 13% is a typo. Closer to 12% for quarter-to-date. So that's very much in line with what we've been doing.
We do not have any further questions in the queue. I will now turn the call back to Mr. Art Penn for closing remarks.
Thank you. I want to thank everybody for their participation. We look forward to speaking to you next in early May.
This concludes today's call. Thank you for your participation. You may now disconnect.