PennantPark Floating Rate Capital Ltd.

Good morning and welcome to the Pennant Park Floating Rate Capital's first fiscal quarter 2024 earnings conference call. Today's conference is being recorded. At this time, all participants have been placed in a listen-only mode. The call will be open for a question and answer session following the speaker's remarks. If you would like to ask a question at that time, simply press star 1 on your telephone keypad If you would like to withdraw your question, please press star 2 on your telephone keypad. It is now my pleasure to turn the call over to Mr. Art Penn, Chairman and Chief Executive Officer of Pennant Park Floating Rate Capital. Mr. Penn, you may now begin your conference.

Thank you, and good morning, everyone. I'd like to welcome you to Pennant Park Floating Rate Capital's first fiscal quarter 2024 earnings conference call. I'm joined today by Rick Oloro, 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 Penn and Park 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 pennandpark.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 31st, how the portfolio was positioned for the upcoming quarters, a detailed review of the financials, then open it up for Q&A. For the quarter ended December 31st, GAAP and court net investment income was 33 cents 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 31st, our portfolio grew to $1.3 billion, or 19% from the prior quarter. During the quarter, we continued 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 3.8 times. The weighted average interest coverage was 2.4 times. 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 and 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 31st, our debt-to-equity ratio was 1.02 to 1. With a target ratio of 1.5 to 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 31st, 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 four new and nine 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 is stable. We had no new non-accruals and the quarter ended December 31st, and we restructured two investments that were on non-accrual, resulting in their return to accrual status. As of December 31st, the portfolio's weighted average leverage ratio through our debt security was 4.8 times, and despite the steep increase in base rates during 2023, the portfolio's weighted average interest coverage ratio at December 31st was 2.1 times. 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 five 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 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 to $50 million of EBITDA, is below the threshold and does not compete with the 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 structure 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 receive 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 have 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 have 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 non-accruals. 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 31st, We have invested over $448 million in equity co-investments and have generated an IRR of 26% and a multiple uninvested capital of 2.1 times. 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 31st, GAAP and core net investment income was 33 cents 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 31st, 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 1113 per share last quarter. As of December 31st, our debt-to-equity ratio was 1.02 times, 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 15th. As of December 31st, 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. Pick income equaled only 2% of total investment income for the quarter. We had one non-accrual, which represents 0.1% of the portfolio at cost and 0% at market value. We did not put any new investments on non-accrual 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 4.8 times, and interest coverage was 2.1 times. 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.

Thank you. If you would like to ask a question, please signal by pressing star 1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press star 1 to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We will take our first question from...

Brian McKenna with JMP great thanks good morning everyone so it's good to see the pickup and origination activity during the quarter and then it seems like this momentum is carried into the new calendar year so you know what's the base case expectation for 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 did the majority of these investments sit from a sector perspective

Thanks, Brian. Good morning. Just to 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 healthcare, in sectors of healthcare that we like that have strong free cash flow and that are performing. And then, you know, just running the gamut of business services are kind of where we've been, you know, 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, Q1. you know, kind of, we do believe as, you know, if we're sitting here a year from now, we'll be in active 2024. Don't know what the ensuing quarters will bring.

Got it. Helpful. And then maybe just a follow-up on leverage, you know, so that, you know, increased pretty meaningfully in the quarter, but, you know, that's from a pretty low base in the prior quarter. So, you know, sitting at about one times 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, like, in what scenario or deployment environment would ultimately drive leverage, you know, notably higher from here?

Yeah, so our long-term target is still about one and a half times area leverage for this portfolio, which is a lower risk first lien portfolio. Look, we take it as it comes. We have a nice, you know, in essence, war chest right now. We believe that this vintage is likely to continue to be a great vintage. We share with you some of the credit stats and low leverage and good low in the 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 non-accrual rate that we've been seeing and, you know, and good credits that. So, you know, when do we get to one and a half times leverage? Again, that goes back to kind of expectations around origination, where the markets are, et cetera. But we feel, you know, good having this nice war chest, being able to take advantage of an excellent vintage and, you know, if we can earn these kinds of NII's and ROE's, you know, less levered, you know, hopefully, you know, there's some really nice upside for our shareholders as we judiciously deploy over time.

Okay, great.

I'll leave it there. Thank you. Thank you.

We will take our next question from Paul Johnson with KBW.

Yeah, good morning. Thanks for taking my questions. You sort of answered my question there, sort of on your outlook, you know, for activity. But just, I mean, I'm curious as to, you know, given this recent quarter here, you know, what drove the higher originations? I mean, was it just, you know, the attractive loans that you saw, or was it anything due to kind of timing, things pending, et cetera? Yeah, it's really all just on the, you know, what drove the high activity in the fourth quarter.

Yeah, and it's a good question. And, you know, our business model is one where, you know, in many cases we're providing that initial loan to a company that's a platform investment for a private equity sponsor who sees a 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. The vast majority of this is kind of platform deals and then the add-on investments to fuel the growth of these sectors. So, you know, typical, you know, investment for us will start out with a company that does, you know, 20 of EBITDA. But, you know, the goal is to get it to 40 or 50 or higher over time. We make our initial platform loan. And then we become their strategic partner. And, you know, you saw quite a bit of, you know, kind of add-on incremental delay draw activity, and that's kind of, that's a big part of what we do and, you know, remains. So, you know, kind of certainly overall M&A trends are important around here, but in many cases, you know, this is driven by fundamental opportunity in particular sectors where our private equity sponsor partners are finding opportunities you know, areas of opportunity. So, you know, kind of active Q4, calendar Q4, you know, we remain active, not as active. We're not as active as we were in calendar Q4. We're active, but not, you know, I'd say we're moderately active, you know, as we speak. But that's just fine. You know, we're not in a rush to play capital. We want to be careful and judicious and selective. And we've learned a lesson that if you force investment, that always backfires. So, We're taking it one deal at a time.

Yeah, 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?

Yeah, so it's a good question. The JV typically, you know, 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 hundred million of liquidity. So over time, you know, 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.

for that. 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 and co-investments that you received during the quarter?

Yeah, 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 three times 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? Are these sponsors who've been holding on, are they going to exit and take the win? 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.

Thanks for the detail, and congratulations on a good quarter. Thank you.

We will take our next question from Mickey Schleen with Lautenberg.

Yes, good morning, everyone. 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. It was just a lot of activity.

There was one or two amendments that were bigger pieces of it, but it was not, it wasn't the main driver. So there was just, you know, quite a bit of activity. Look, we had quite a bit of a new loan activity.

It was just an active quarter overall.

Okay. And in terms of your unfunded commitments, In the queue, 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 delay draw, right? So the revolvers are at the company's discretion. Delay draw, typically, they have to meet some kind of covenants or performance thresholds. And they have to find out on deals, typically. Typically, that's why they do delay 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 late draws were lesser a part of it then, in times of turmoil, many borrowers will borrow from the revolver, but the late draw activity will go to zero because there's no add-on acquisition. So if you look at the couple hundred million that we have, it's about half and half. If there were to be any kind of COVID type or emergency scenario, you know, the revolvers would maybe not be fully drawn, but at least half drawn, but the late draw activity would go to zero.

Okay, fair enough. Talking about the right side of the balance sheet, Art, you're now in a position where about three-quarters 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?

Yeah, I think before unsecured debt, the CLO securitization technology is a really good liability management tool, particularly for these lower risk first lien loans. You know, 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 as a CLO middle market manager in our BDCs and our JVs as well as for third-party investors. So probably step one to create liquidity for the revolver is the 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, you know, a forehandle. So, you know, 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 very 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?

Yeah, I mean, it would probably be low 200s, 230-ish.

Okay, that's interesting. Those are all my questions this morning. Thank you for your time, Mark.

Thank you, Mickey.

We will take our next question from Mark Hughes with Truist.

Thanks, good morning. Art, you described pretty good interest coverage there, 2.1 times, I think, for the portfolio. Can you say anything about what proportion may be closer to one time or below? And any sense on how you think credit will trend over the next six, 12 months?

Yeah, so... You know, don't have it at our fingertips, you know, the lower interest coverage. Look, there's a handful of deals. You know, we have, you know, over 100 deals, 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 three to five to six that are kind of on, you know, major watch. Mm-hmm. 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 eat away? 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? You know, 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, you know, grinding away here, you know, kind of with tighter coverage. So You know, right now we're in a pretty good position. You've seen, you know, very low non-accruals. Again, only a handful of names that are kind of more on the severe watch list. But, you know, we're staying watchful and cautious. And certainly on the new deals that we're doing and we shared with you the credit stats, we're finding some really great lower risk, attractive return investments. And as the portfolio grows and gets populated with this vintage trend, you know, some of the handful of deals that are underperforming will become even less significant in the overall scheme.

Yeah, 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. Those covenants, how do they compare to 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?

Yeah, I'd say we're kind of back to kind of pre-COVID levels with reasonable cushions that protect us. And we do get the monthly financial statements. I'd say we're back to pre-COVID. Certainly, if you look at 2022 and early 2023, It was tighter, you know, we could get tighter. You know, 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 a COVID and did during a COVID scenario really get to the table early because of the quarterly maintenance tests which you know 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 information rights, which really 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, or 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. You know, when we talk about the core middle market versus the upper middle market and the pluses and the minuses, and, you know, we really like this core middle market where these protections and information rights really kind of get us to the table quick.

Thank you very much.

We will take our next question from Vilas Abraham with UBS.

Hey, everybody. I just had a question on repayments.

Can you share any kind of line of sight that you have into repayments, prepayments for the first half of the year? Presumably, if origination activity continues to be strong, repays should pick up as well. Just kind of talk about that and if that would be a bit of an impediment in getting to your leverage goals.

Yeah, look, we are starting to see repayments. It's not a wave. There's certainly nowhere near being equal to our originations. But repayments indicate that M&A 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 ringing 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 originating new deals. Again, we don't sit here and say, gee, we've got to get to one and a half times because the research community wants to see it. happen in their model in the next, you know, two or three quarters. We try to, and what we do is each deal has to make sense on its own two feet. It's a very rigorous process that we go through. We'll get there when we get there. You know, we're healthily beating our dividend even as we speak in an underlevered environment and also an environment where JV is also not fully deployed. So, you know, we're earning, you know, 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, you know, a war chest to select hopefully great deals in what should be or what remains what we think a 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 that usually doesn't work out well. and the deal flow will come. We do think it will be, we think 2024 will be an active year.

Okay, great.

And then just my other question, just on yield and spread dynamics, it looks like your Q4 average yields for new deals were 11.9%. The average portfolio is higher than that. But then quarter-to-date yields, I think I saw around 13% on weighted average yields. So can you just kind of talk about, you know, it looks like a little bit of choppiness there and kind of what to expect trend-wise there in the near term?

Yeah. Yeah. That's a typo. 13% is a typo. It's closer to 12% for quarter-to-date. So that's, you know, very much in line with what we've been doing.

Got it. Okay. Thank you. Thank you.

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.