PennantPark Investment Corporation (PNNT) Q1 2012 Earnings Report, Transcript and Summary

Good morning and welcome to today’s PennantPark Investment Corporation’s First Fiscal Quarter 2012 Earnings Conference Call. Today’s call is being recorded. [Operator Instructions] It is now pleasure to turn the conference over to Mr. Art Penn, Chairman and Chief Executive Officer of PennantPark Investment Corporation. Mr. Penn, you may begin.

Thank you and good morning, everyone. I’d like to welcome you to our first fiscal quarter 2012 earnings conference call. I’m joined today by Aviv Efrat, our Chief Financial Officer. Aviv, 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. Audio replay of the call will be available by using the telephone numbers and pin provided in our earnings press release. I’d also like to call your attention to the customary Safe Harbor disclosure in our press release regarding forward-looking information. Today’s call is -- 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 SEC filings, please visit our website at www.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.

Thank you, Aviv. I’m going to spend a few minutes discussing current market conditions, followed by discussion of investment activity, the portfolio, our overall strategy, and then open it up for Q&A. As you all know, the economic signals have continued to be mixed to slightly better with many economists expecting a flat to slowly growing economy going forward. With regard to the more liquid capital markets and in particular the leverage loan and high-yield markets, starting in the middle of 2011, the quoted of prices of liquid leveraged finance assets saw downturn during the summer and remained fragile through the end of the year. The market softness has brought a much needed breather to the more liquid capital markets which had rallied for 2 years. As investors, we appreciate the pause in the more liquid capital markets and are pleased that there is more skepticism in the market. We have been benefiting on both the primary side of our business as well as taking advantage of selected opportunities in the secondary market. That said, the liquid credit markets have rallied so far in 2012 as cash flows and the leveraged loan in high-yield funds have been strong. As debt investors and lenders, a flat economy is fine as long as we’ve underwritten capital structures prudently. A healthy current coupon with de-leveraging from free cash flow over time is a favorable outcome. We remain focused on long-term value and making investments that will perform well over several years. We continue to set a high bar in terms of our investment parameters and remain cautious and selective about which investments we add to our portfolio. Our focus continues to be on companies or structures that are more defensive and have low leverage, strong covenants and high returns. We significantly reduced competition in the middle market. We’ve taken advantage of the 2009 through 2011 vintages. The upcoming 2012 vintage should remain solid. With plenty of dry powder, we’re well positioned to take advantage of the market opportunity. As credit investors, 1 of our primary goals is preservation of capital. If we preserve capital, usually the upside takes care of itself. As a business, 1 of our primary goals is building long-term trust. Our focus is on building long-term trust with our portfolio companies, management teams, financial sponsors, intermediaries, our lenders and of course our shareholders. We are a first call for middle market financial sponsors, management teams and intermediaries who want consistent credible capital. As an independent provider, free of complex or affiliations, we’ve become a trusted financing partner for our clients. As the market has got more active, we are completing more transactions for well regarded financial sponsors with whom we’ve had long-term relationships. Since inception, PennantPark entities have finance companies backed by 81 different financial sponsors. We have been active and are well positioned. For the quarter ended December 31, 2011, we invested about $43 million with an average yield on debt of 16.4%, up from 12.8% the prior quarter. Expected IRR generally range from 13% to 18%. We have some attractive investments which did not get closed by year-end but were closed in early 2012. Since December 31, we have invested $73 million. Net investment income was $0.33 a share. We have made our goal of steady stable and growing dividend stream since our IPO about 5 years ago despite the overall economic and market turmoil. We announced the dividend increased to $0.28 a share for the December quarter. We are in the process of renewing our credit facility on attractive terms. The facility will have a 4-year maturity with a 1-year term out after year 3, will be priced at LIBOR plus 2.75%. The size will be at least $350 million. We appreciate the support and long-term partnership of lending community to our company. To enhance our liquidity to take advantage of opportunities in the market in late January, we raised $105 million of net proceeds in an equity offering. Incremental float in liquidity in our shares should continue to help attract investors to our stock. In the last couple of weeks, the Standard and Poor’s and Fitch, have rated our debt investment grade BBB-. This is a significant milestone for our company as it confirms our solid track record over time and the institutionalization of our business. Importantly, it should help us continue to raise debt capital efficiently over time. As a result of our focus on high-quality new investments, solid performance of existing investments and continuing diversification, our portfolio is constructed to withstand market and economic volatility. The cash interest coverage ratio, the amount by which EBITDA or cash flow exceeds cash interest expense continued to be healthy 3x. This provide significant cushion to support stable investment income. Conditionally at cost, the ratio of debt to EBITDA on the overall portfolio was 4.6x, another indication of prudent risk. The structure of our investments in the portfolio is relatively low risk as well. It consists primarily of cash paid debt instruments and only 9% of the portfolio is preferred and common equity. We’re pleased with the performance of the portfolio through the stress test of the last few years. During the recession, on a weighted average basis based on cost, the EBITDA of the core portfolio was down only 7.2% from initial investment to its lowest point. We have plenty of liquidity. As of December 31, we had in total about $190 million of available liquidity, which included $123 million available under our credit facility, about $26 million of assets with coupons less to 9% which we intend to continue selling or rotating into higher yielding new investments and $41 million of cash in our SBIC. With the proceeds of the equity transaction and an upsize credit facility, we have plenty of dry powder. We continue to grow our SBIC and Aviv will give an SBIC update later. We’re looking forward to applying for a second SBIC license when appropriate to be able to access up to another $75 million of debt capital. As a reminder, we have exempted relief from the SEC to exclude SBIC debt from our asset coverage ratios and SBIC accounting as cost accounting, not mark-to-market accounting. These facts highlight how the SBIC debt reduces overall risk of our company. We had some significant realizations last quarter. Our $29 million position in Kadmon Three River’s debt was refinanced and generated an IRR of 26%. Consolidated foundries were sold and our $8 million debt investment was taken out at an IRR of 14.5% and our equity and investment in the equity generated an IRR of 36%. Out of the 116 investments have made since inception about 5 years, we’ve had only 5 companies on non-accrual, 4 of which have been reorganized. Last quarter, as expected, 2 of those companies went on non-accrual, Hanley-Wood and DirectBuy. The Hanley-Wood restructuring was the catalyst that we had been anticipating in order to convert a portion of our debt investment to equity and capture some upside in the company at an attractive valuation and at an attractive point in the cycle. As of December 31, Hanley-Wood was only an $8.7 million position or 1% of the portfolio at cost and 0.5% of market value and the income that was being generated at LIBOR+225 was not material. The market value of that position as of December 31 was $4.2 million. Hanley-Wood was the first default we’ve had in nearly 2 years. The restructuring was completed quickly and as of today, we have $1.8 million piece of cash paying debt and $2.5 million of equity including an additional $800,000 equity investment we made as part of the restructuring. The company comes out of the restructuring as an industry-leading, high-quality, low leveraged company. With regard to our investment in DirectBuy, we are disappointed with the situation and the debt continues to trade poorly. The November 1 interest payment was made but the February 1 interest payment was not made. As a result, we put the investment on non-accrual as of November 2. As of December 31, the investment represented 3.8% of the portfolio at cost and 1% on a market value basis. We are continuing diligence on the company and the situation. In any event, we do not believe that this situation is a material to the earnings of PNNT. To refresh your memory about our business model, we try as hard as we can to avoid mistakes but defaults and realized losses are inevitable as a lender. We are proud of our track record of underwriting credit through the cycle. One way we mitigate those losses is through our equity co-investment portfolio. Realized gains on investment such as consolidated foundries help offset the inevitable losses that we have from time to time. We are optimistic that our co-invest portfolio which includes the name such as TriZetto, [indiscernible], Magnum Hunter, Kadmon and Veritext will generate gains over time. From an interest rate standpoint, 8% of the portfolio has an interest rate that floats, another 29% floats but has a floor which protects income in this low-based rate environment and the remaining 63% is fixed rate. In terms of new investments, we had another quarter investing in attractive risk-adjusted returns. Our activity was driven by mixture of M&A deals and purchases in the secondary market at a discount. And virtually, all these investments we’ve done with these particular companies for a while, have studied the industries have a strong relationship with the sponsor for a differentiated information flow. Let’s walk through some of the highlights. We invested $17 million in the subordinated debt and about $2 million in the equity of JF acquisition. JF is a leading provider of repair and maintenance distribution and installation services to the fueling infrastructure industry. MidOcean Partners is the financial sponsor. We also invested in select secondary market opportunities and names we know well in the existing portfolio such as [indiscernible] and Brand at attractive risk-adjusted returns. The turmoil and the liquid markets resulted in those opportunities. Turning to the outlook, we continue to believe that the remainder of 2012 will be active. We’re seeing a significant amount of middle market M&A, which over time should drive a substantial portion of our investment activities. Much of our business will be driven by companies that need a financing solution and don’t have many options as finance companies, CLOs and local banks have exited the market. Due to our strong sourcing network and client relationships, we are seeing strong deal flow. Let me now turn the call over to Aviv, our CFO, to take us through the financial results.

Thank you, Art. For the quarter ended December 31, 2011, investment income totaled $26.8 million and expenses totaled $11.8 million. Management fees totaled $7.8 million. General and administrative expenses totaled approximately $1.6 million. SBA and credit facility interest expense totaled about $2.4 million. Accordingly, net investment income was $15 million or $0.33 per share. This includes $0.04 of other or non-recurring income. During the quarter ended December 31, net unrealized gain from investments was $10 million or $0.21 per share. Net realized loss was $8 million or $0.18 per share. Unrealized loss from appreciation of the credit facility was $1.1 million or $0.02 per share and excess net investment income over dividend was approximately $2.2 million or $0.05 per share. Consequently, entity per share went from $10.13 to $10.19 per share. As a reminder, our entire portfolio and our credit facility are marked-to-market by our Board of Directors each quarter using the exit price provided by an independent valuation firm or independent broker dealer quotation when active markets are available under ASC 820 and ASC 825. In cases where broker dealer quotes are inactive, we use independent valuation firms to value the investments. Our overall debt portfolio has a weighted average yield of 13.2%. On December 31, our portfolio consisted of 46 companies and was invested 32% in senior secured debt, 20% in second lien secured debt, 39% is subordinated debt and 9% in preferred and common equity. However SBIC has drawn the maximum amount, $150 million of SBA debentures and we had $41 million of cash available as of December 31. We feel fortunate to have a lot in the entire $150 million at a fixed all-in rate of 4% for 10 years when treasuries were near all-time lows. We are exploring applying for a second SBIC license when appropriate, which would result in up to additional $75 million of SBA loan. As of December 31, undistributed taxable net investment income in excess of dividend paid was approximately $7.6 million or $0.17 per share as of December 31 providing cushion for future dividends. Now let me turn the call back to Art.

Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is a steady stable and growing dividend stream. 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 debt instruments and payout those contractual cash flows in the form of dividends to our shareholders. In closing, I’d like to thank our extremely talented team of professionals for their commitment and dedication. 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 the call to questions.

[Operator Instructions] And we’ll go to Joel Houck with Wells Fargo for our first question.

My question is really more, broader around the industry as I’m sure you are aware, yesterday, larger BDCs and after restructuring and notwithstanding the main changes, they indicated the different directions and more private assets. I guess the question is 2, for 1, do you see that impact as they come down more into your style of credits as that impact returns? And second, how do you strike a balance between the more liquid securities that are perhaps more volatile versus where we would consider higher alpha in the private middle market deal. How do you look at that in terms of balancing your own portfolio?

That was a great return -- that’s a great question Joel and very topical. I guess, in terms of competition, we have to see everyone is our competition, whether it be other BDCs, whether it be the private GP Mass funds, whether it be TLOs, et cetera. We still think there is a mass of opportunities in the market. We’re just scratching the surface in terms of financing, middle market companies with banks and others, and finance companies kind of moving away from the market. You could add a lot of competition. We still think there is going to be great risk reward in the marketplace. And the important thing is that, competitors behave rationally. We believe the folks, the folks of the Power [ph] and generally very rational. And you know we welcome rational competition. In terms of liquid versus illiquid, it’s something at least we think about all the time. We like having a portion of our portfolio in liquid instruments, both from an offensive standpoint and a defensive standpoint. Although, the overall portion is probably moving down over the coming quarters, given volatility of NAVs and protecting ourselves against some event in Greece or Spain or Portugal or wherever. We do like having, call it, 20% to 25% in liquid instruments both for defensive purposes, which is, if you need liquidity, liquid sites to be able to do that, to access that. And also, there are times in the market where people give you dollars for $0.80, because they are scared. And if you have a real, really nice view of the credit, you have good information flow you’ve got good relationships with the management team and the sponsor. If you can pick up a $1 for $0.80, you should try to do that. And that’s one of the ways, you can create upside in your portfolio. As a lender, we recognize every day that we’ve got a lot of downside relative to our upside and are good deals get taken out. And we’re left with sometimes with the deals that aren’t so good. So, we’re always looking for ways where we can take that asymmetry and make it a little bit better, whether it be equity co-investment from time to time, whether it be warrants from time to time or whether it be buying paper in the more liquid market at discounts when others are scared. But we do think, for us, 20%, 25% is a prudent liquid portion of our portfolio, which is lower than it has been historically. Because, we really do like the private scenarios where we’re in there, where we’re driving the financing, we’re driving the covenants, we're in a more controlled position to the extent something goes wrong. So, that will continue to be -- the vast majority of our portfolio will be those self-originated private, illiquid, highly negotiated transactions.

We’ll go next to Greg Mason with Stifel, Nicolaus.

Art, you have pretty impressive yields this quarter on your new investments. That $73 million of assets that got pushed into January, can you give us any color on those types of investments where they primarily, these proprietary middle market private deals and what coupons you are seeing on those?

Yes, those -- well, that primarily was our, private self-originated deals in the 13% to 14% zone.

Okay, great. And then, on the new credit facility, if it’s done, one of the things you had on the last minute, you’re able to take, FAS159, the mark-to-market of your liabilities. Will you be able to take that again on the new credit facility or how does that work?

Yes, I know, it’s a good question. We haven’t gone public yet with the final terms. But unfortunately, the banks have been clamping down on that. You can look at recent other BDC credit facilities. And that will be one of the tweaks, that will come out of this credit facility. So, we will still use 159 and we’ll still provide protection for the SECS asset coverage desk. So, we still think that’s a proper insurance policy to have, the SECS Asset Coverage Test. But it looks like in this upcoming credit facility, we will not get that ability for the credit facility covenants to use the 159. We still think it’s a very attractive facility with lots of flexibility. We obviously were appreciative of the upsizing, which is nice. We think the pricing L plus 2.75% is attractive also. So, generally we’re very, very pleased but it probably will not have that 159 in it.

And then, with a potential size of 350 that you mentioned, you have -- would have a significant amount of capacity there in that credit facility. Yet, you also got an investment grade rating which I think should open up some, bond markets or other private debt issuance to you, but probably at higher cost versus the L plus 2.75%. So, as you think about your capacity and where you want to move your capital structure, how are you thinking about your liabilities and what bucket you put them in going forward?

That’s a great question. It’s something -- first of all there is nothing near term really to talk about. We’ve got an upsized credit facility. We just raised equity. We have SBIC, too, we’re going to go for. And there is potential legislation which could increase the SBIC buckets over the course of next 12 months which would be great. That’s obviously very cost effective financing. But look, we’re going to look overtime to diversify our financing sources. We think that’s the proper way to manage the company. Though there is -- there is, other methodologies to finance BDCs, there is private debt sold to insurance companies that’s usually secured. There is baby bonds which BDCs are now doing well. There is potentially at some point converge. It’s been out of favor recently but potentially converge, etcetera. So, there is, all kinds of different flavors of debt. We think it’s prudent to have, a myriad of different debt financing sources over time as we grow. We will, hopefully, judiciously link into some of those.

We’ll go next to John Stellar with SunTrust. [Technical Difficulties]

We’ll go next to Jasper Burch with Macquarie.

This is Jasper with Macquarie. Art and Aviv, just following up on Greg’s question, on the new facility, good job with the rate on [indiscernible] attractive. But I was just wondering if you could give us color on what their revolving period might be and if you have a term-out on it?

Yes, we disclosed this at say 40 or final with a term-out after year 3.

We’ll go next to Arren Cyganovich with Evercore.

If you could just talk about the leverage in where you’re willing to take that. You have the SBIC exemption and you just kind of raised capital, your leverage excluding the SBIC’s was not particularly high. Is there any kind of guidance that you’ve been given from the rating agencies that have to keep their leverage low at relatively low level to get your investment grade rating?

They don’t give us guidance. We told them what our general zone is. Our general zone is 0.6 to 0.8 times. That’s our general zone. Obviously, both for offensive and defensive purposes, we can take it significantly above that particularly with the SBIC exemption. Not our anticipation now, it would either mean, for defensive purposes, we need to increase leverage more because we see such amazing deals in the marketplace that we want to nudge it up a little bit. But those would be unusual circumstances. In general, 0.6 to 0.8 is the -- it’s the zone of where we’re targeting.

And that’s inclusive of the SBIC debt?

That’s inclusive of the SBIC debt.

Okay. And then, also could you talk about, you have several, not several but a few investments that are 100% pick. What’s the process for, putting a company on 100% pick status. It doesn’t look like there are any issues with the companies, just, maybe just a financing mechanism, they’re using, just have a little clarity on that?

Yes. Look, we don’t like 100, we don’t like picked to just to put it out there we hit pick, okay. So, it’s part of the industry unfortunately. In some cases, we have to deal with it, we have to manage it. We have to maintain our liquidity to deal with it. So, we don’t do any all-pick deals unless we view them, in the way that we view them, which is really equity. Sometimes, the company will under-perform and as part of an amendment, you go all-pick for a while, that’s usually not a good news event. But it’s something that we really try to avoid.

Okay. And then, did you mention what you have in terms of exits or sales from the portfolio year-to-date?

They, it’s -- what is it Aviv?

About 68 million or so that we have exited during the quarter.

During the quarter, end of December. Are you talking about the quarter end?

I said, year-to-date this year, kind of maneuver.

So, you’re talking about March. There are 2 companies that and these are just about public information that have taken that have refinanced this out. One is, a company called Ram Energy, they got basically taken over. And they’ve got big equity injections. So, net-net, it was refinanced down. And we have an investment or we had investment in Chester Downs, and that got taken out by a high-yield deal.

[Operator Instructions] And we’ll go to Casey Alexander with Gilford Securities.

I didn’t -- I don’t remember exactly, what was the -- what would the percentage that you had on non-accrual at the end of the quarter, was it 2% of the fourth volume?

Well, we’ll give it to you on both and market. On cost, it’s 4.8%. On market it’s about 1.5%.

Around 1.5%, okay. Secondly, on your unrealized gains, the statement in the release was that it was due to changes in the leveraged credit markets. But you did take a realized loss. Was there some portion of the unrealized gain that was actually a reversal of previously unrealized loss?

No, I mean, what happened was we had a realized loss, which was due to our exit of a -- of Aquilex, which was an investment that didn’t work out for us. We decided to exit, that was the primarily reason for the realized loss. Unrealized gains that we had and so, between Aquilex, that was a realized loss. We had some unrealized losses from direct buy, which offset some of the unrealized gains we had in the overall portfolio, the leveraged loan in high yield markets were up in general over the quarter.

So, Aquilex, Aquilex had not been written down before, it was just something that you recognized in the quarter and took the loss?

It had been written down but wasn’t realized. So it became -- we went from an unrealized loss to a realized loss.

So, there was some reversal of an unrealized loss then?

Correct. So, probably it was for me, the unrealized loss to realized loss for that particular thing as an example.

We’ll go next to John Hecht with JMP Securities.

First question, Art, I think you talked about the EBITDA from peak to trough in terms of the trends of the market. What can you tell me of the EBITDA performance of the portfolio companies over the past say 3 to 6 months?

I mean, we track it from inception I have that off the top of my head. But I, it get back to enlist, 3 to 6. In general, from inception to the day, it’s up, call it, 15-ish percent. At the bottom of that 15%, so at the bottom of the recession, it was kind of down 7%, now it’s kind of up 15%.

Okay. And you guys are historically focused on more secured senior type investments and of course you met with some uncertainties with respect to Europe, et cetera. But if those clouds are lifted and you feel better about the economy, would you take this more subordinate portion of the -- of a particular capital structure in order to increase your overall yields?

Look, we look at every deal on individual deal by deal basis. Clearly, the farther you go down, the capital structure, the clear picture you need to have because recoveries are not as good. So, we take every investment very seriously. Obviously if you’re way at the top of the capital structure, you got more cushion than if you are in the subordinated piece. So, it’s deal by deal, company by company, industry by industry. We’re looking for the best risk reward where we can get it. With the focus on, number one, preservation of capital.

Okay. And can you give us an update in your perspective of the M&A trends in the middle market and what that might need for deal flow over the next couple of quarters?

So, we’re going through what we would call the typical January factor, where January is usually pretty slow as the deal machinery takes a little while to get out of the gates. It has been a little slow in terms of M&A. We’ve been active because a lot of our deals kind of float over from the December quarter into the January quarter. That’s why we’ve been, down to $77 million so far this year. But those were really 11 deals that didn’t make it in, before December 31. So, things have started to percolate up again in terms of M&A. But it’s still a little slow quarter-to-date, we can’t really give you any guidance to what’s going to close where March 30 or not. The liquid capital markets as we said in the preface have been rallying, it’s something to be focused on just in terms of if people start getting silly again, they start miss-pricing risk reward again, it does certainly hurt the liquid markets, and it does in some way trickle down to illiquid markets as people lose fear. We like a little bit of fear in the market for us because that makes, for better risk reward and better negotiations. So people continue to lose fear. And if you see, people doing secondly deals at 9% or 10% which does as really missed price to mezzanine risk, should be 13% to 14%. We started seeing 9%, 10% second lien deals again just like you saw at the beginning of ‘11. That’s kind of a warning signal, at least for us to stand down, and get less active we never raise our bar picking this, et cetera. So, you may see some of that as the high-yield mutual fund flows and leverage to loan flows have been positive, it’s something to watch out for.

Okay. But just putting aside the trends in the capital markets, are you hearing a greater eagerness from stock shares to put money to work, more acceptability on the business owners to put businesses on the market and willing to sell. It’s just sort of a secular trend that we may look for over the next 4 to 8 quarters?

It’s more of the same John that we’ve seen over the last year. Sponsors do have a lot of money to deploy and they are willing to plough. Thankfully, we have a lot of equity underneath us. We’re seeing, many cases, 40% to 50% equity checks underneath the debt in many of these capital structures. Sponsors have a lot of money. Middle market M&A machinery should be decent for ‘12, we think it will be just fine. It just takes a little while for that machinery to get going in the typical January timeframe which is, this is the way things work in the middle market, where people try to get deals done by yearend. They take a break and then they start it again in January. And typically you see a little bit of seasonality in our business where, in quarters 2 and 3 and sometimes quarters 4 on the calendar year basis, are having link in the calendar 1, in the Q1.

[Operator Instructions] We have no questions in the queue. I’d like to turn the call back to our presenters for any additional or closing remarks.

Thank you, everyone, for your time today. And we look forward to talking to you next quarter.

Ladies and gentlemen, that does conclude today’s conference. We thank you all for joining.