PNNT - NYSE

Hello, and welcome to PennantPark Investment Corporation's Third Fiscal Quarter 2025 Earnings Conference Call. [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. Welcome to PennantPark Investment Corporation's earnings conference call for the third fiscal quarter 2025. 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. I'm going to spend a few minutes and comment on how we fared in the quarter ended June 30. Our dividend coverage and spillover income balance, the current market environment for private middle market credit and how the portfolio is positioned for upcoming quarters. Rick will provide a detailed review of the financials, and then we'll open up the call for Q&A. We are encouraged by a recent resurgence in deal activity which we anticipate will result in increased loan originations and potential exits of some of our equity positions during the second half of 2025. Additionally, we continue to provide additional capital to many of our existing portfolio companies as they execute their respective growth plans. Our platform continues to prove its strength as we support our existing portfolio companies and private equity borrowers with strategic capital solutions to help grow their businesses. With regard to how we fared in the quarter ended June 30, our core net investment income was $0.18 per share compared to total distributions of $0.24 per share. We've previously communicated our plan to rotate out of our equity positions and redeploy that capital into interest-paying debt investments, which will drive an increase in our core net investment income. We remain focused on this strategy and are comfortable maintaining our current dividend level in the near term as the company has a significant balance of spillover income, which we are required to distribute. PNNT has $55 million or $0.84 per share of undistributed spillover income, and we will use the spillover income to cover any shortfall in core net investment income versus the dividend while we position ourselves for equity rotation. We are encouraged by increased M&A activity in the market and believe that this growing activity level will result in meaningful cash realizations in our equity portfolio. Looking ahead, we expect origination activity to be a mix of our existing portfolio companies and high-quality new investment opportunities. We believe that the strongest assets -- those with demonstrated growth and tariff resilience will still command premium valuations and attract sponsor interest. With regard to asset pricing, in the core middle market, the pricing of first lien term loans is SOFR plus 4.75% to 5.25% for high-quality assets. As always, we will remain rigorous in our underwriting and highly selective in pursuing new investments. We continue to see attractive investments in the core middle market. During the quarter, for investments in new portfolio companies, the weighted average debt-to-EBITDA was 3.8x. The weighted average interest coverage was 2.6x and the yield to maturity was 10.2%. The credit statistics just highlighted indicate, we continue to believe that the current vintage of core middle market directly originated loans is excellent. In the core middle market, leverage is lower and spreads are higher than in the upper middle market. We continue to get meaningful covenant protection, while the upper middle market is primarily characterized as covenant light. As of June 30, the portfolio's weighted average leverage ratio through our debt security was 4.7x, and the portfolio's weighted average interest coverage ratio was 2.5x. These attractive credit statistics are testament to our selectivity, conservative orientation and our focus on the core middle market. We continue to believe that our focus on the core middle market provides the company with attractive 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 in which we possess the deep domain expertise, enabling us to ask the right questions and consistently deliver strong investment outcomes. They are business services, consumer, government services and defense, health care and software and technology. These sectors have also been recession-resilient and to generate strong free cash flow and have a limited direct impact to the recent tariff increases and uncertainty. For middle market, companies with $10 million 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. The core middle market, because we are an important strategic lending partner, the process and package of terms that 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 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 and meaningful covenants, which help protect our capital. Credit quality of the portfolio has remained strong. We have 4 nonaccruals as of June 30, which represented 2.8% of the portfolio at cost and 0.7% of market value. Two new investments were added and one prior investment was removed as it returned to accrual status. Subsequent to quarter end, one nonaccrual investment was put back on accrual and pro forma for the subsequent event PNNT's nonaccruals represent 2.6% of the portfolio cost and 0.6% at market value. Since inception, nearly 18 years ago, PNNT has invested $8.9 billion at an average yield of 11.25% and has experienced a loss ratio on invested capital of approximately 20 basis points annually. This strong track record includes investments on primarily subordinated debt investments made prior to the financial crisis, legacy energy investments and recently the pandemic. As a provider of strategic capital that fuels the growth of our portfolio of 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 June 30, we've invested over $583 million in equity co-investments and have generated an IRR of 26% and a multiple on invested capital of 2x. As of June 30, our portfolio totaled $1.2 billion and during the quarter we continue to originate attractive investment opportunities and invested $88 million in 4 new and 28 existing portfolio companies at a weighted average yield of 10%. Our PSLF joint venture portfolio continues to be a significant contributor to our core NII. At June 30, the JV portfolio totaled $1.3 billion and during the quarter, the JV invested $22 million at a weighted average yield of 9.8%. In the last 12 months, PNNT's average NII return on invested capital in the JV was 17.9%. The JV has the capacity to increase its portfolio to $1.6 billion and we expect that with additional growth in the JV portfolio, the JV investment will enhance PNNT's earnings momentum in the future quarters. July 2025, PSLF partially refinanced its $300 million debt securitization. PSLF refinanced the non-AAA tranches and decreased the securitizations weighted average spread by 68 basis points to 2.63% from 3.31%. From an outlook perspective, our experienced and talented team and our wide origination funnel is producing active deal flow. We remain steadfast in our commitment to capital preservation and disciplined patient investment approach. We reiterate our objective to deliver compelling risk-adjusted returns through stable income generation and long-term capital preservation. 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, GAAP and core net investment income was $0.18 per share. Operating expenses for the quarter were as follows: interest and credit facility expenses were $9.2 million. Base management and incentive fees were $6.4 million. General and administrative expenses were $1.5 million and provision for excise taxes were $0.7 million. For the quarter ended June 30, net realized and unrealized change on investments and debt, including provision for taxes was a loss of $3.6 million. As of June 30, our NAV was $7.36 per share, which is down 1.6% from $7.48 per share in the prior quarter. As of June 30, our debt-to-equity ratio was 1.3x, 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 158 companies across 37 different industries. The weighted average yield on our debt investments was 11.5%. We had 4 nonaccruals, which represent 2.8% of the portfolio at cost and 0.7% at market value. Subsequent to quarter end, one nonaccrual investment was put back on accrual and pro forma for this subsequent event, nonaccruals represent only 2.6% of the portfolio at cost and 0.6% at market value. The portfolio is comprised of 46% first lien secured debt, 2% second lien secured debt, 13% subordinated notes to PSLF, 5% other subordinated debt, 7% equity in PSLF to 27% in other preferred and common equity co-investments. 90% of the debt portfolio is floating rate. Debt to EBITDA on the portfolio is 4.7x and interest coverage is 2.5x. Now let me turn the call back to Art.

Thanks, Rick. In closing, I want to express my gratitude to our dedicated team of professionals for their unwavering 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'd like to open up the call to questions.

[Operator Instructions] And our first question comes from Brian McKenna with Citizens.

Great, thanks. Art, I appreciate all the detail on the outlook into the back half of the calendar year. On the equity rotation opportunity, specifically, if M&A activity continues to accelerate here over the next several quarters, what's the ideal time line to sell a good chunk of the equity portfolio and then reinvest that capital? And then I'm assuming there's some meaningful unrealized gains in this part of the portfolio. So do you plan to pay out a substantial amount of these gains once realized in dividends? Or will you kind of look to hold off on paying incremental dividends and redeploy kind of the majority of that capital into new loans.

Thanks, Brian, and thanks for the question. In terms of timing, look, we believe that M&A will resume, we're seeing it. So we think over the next 12 to 18 months, there's going to be significant progress, hopefully rotating out of both of our equity co-invest, which we don't control and perhaps some of our control positions, which are some of the bigger, chunkier names. So kind of a 12- to 18-month horizon, we'll have to see in terms of what the characteristics are, but our anticipation is to take the capital and roll it back into yield so that we can generate healthy NII for our shareholders.

That's helpful. And then just on the balance sheet, leverage stands at about 1.3x today. I'm assuming that's a reasonable expectation over the next few quarters here. But once a meaningful portion of the equity portfolio is, in fact, rotated into the first lien loans. I mean should we expect the leverage target to move a little bit higher here, similar to PFLT?

Yes. Look, it's a good question. I think just from the standpoint of matching, we think, a first lien portfolio or certainly a heavier first lien portfolio could judiciously handle a little bit more leverage. So that would be a fair assumption, assuming the portfolio kind of normalizes over time.

And our next question will come from Robert Dodd with Raymond James.

On the spillover income, obviously, $0.84. And I mean, at the pace you're earning obviously, forward curves, et cetera, et cetera. But I mean, you're only $0.06 short a quarter right now, that spillover would tide you over for a long time if you wanted to. But can you give us any color on like where -- at what point would -- in terms of working down that spillover, would you think it's low enough and it would be time to evaluate the dividend. I mean your earnings profile might be different at that stage, obviously. But at what point do you think that's low enough that an evaluation needs to be made on that?

Yes. So look, I think that kind of jives with the prior question, Robert, which is when can we normalize this portfolio and once we normalize the portfolio and when can we rotate it into yield. So we think that's a year, 1.5 years out kind of over time, be able to do that, come up for air after we normalize things. And take a look at what's sustainable, how much spillover we have at that point in time and kind of reset the table at that point in time. But as we're kind of working that rotation down, we think we just want to kind of keep it as it is.

Got it. Got it. On looking at the outlook for obviously, M&A, as you said, right, it's ramping up, the outlook does look better. When you look at the portfolio leverage at 4.7x, interest coverage of 2.5x, that should improve if base rates come down. On the originations that you think the market terms right now, would you expect that like leverage to be rising from here in the portfolio or holding steady. I mean, interest coverage improving? Obviously, I mean, what kind of -- what are market terms today on the deals you're looking at versus what the average is in the portfolio right now?

Yes. So it's a good question. And just to reset it. When we typically start a new platform, it's a little bit of a smaller company. It's being bought from founder entrepreneur. And the leverage will be lower at that point in time. It will be a smaller company, leverage will be lower. The new loans we made in this past quarter, debt-to-EBITDA was 3.8x. Out of the gate, interest coverage was 2.6x. And that's kind of a new platform for us as the company matures as the company does add-on acquisitions as the company gets larger, it kind of has been balancing out to 4.7x debt-to-EBITDA for the entire portfolio. So that's typically when it becomes over time. We generally have an aversion to going above 5x. I mean we will do it occasionally when we have real conviction or it's a larger company or we just feel like it will derisk or deleverage relatively quickly. So rarely do we start out in a loan where it's above 5x. That's just the way we're constitutionally set up. And what it will mean also is probably a lower yield, but we're okay with that. We're okay with being on the lower risk end of the spectrum in the direct lending market. So hopefully, that gives you an answer to your question.

Yes, it does. That's very helpful. And then one more, if I can. I mean you talked about the time line 12 to 18 months for equity rotation as well. Obviously, there's some chunky positions in there. It did sound in your opening remarks that you seem a little bit more optimistic about maybe a couple on a shorter time frame? Or are there any that are like actually in the works that could happen this year? And would those -- if they do, would those actually be material? Are you talking about maybe realizing some small positions this year?

Yes. So we are starting to see some rotation in the kind of equity co-invests. These are the singles and doubles, and we're starting to see that, which is nice. Some of those kind of core middle market companies are getting sold. We have pieces that are $1 million to $5 million in value, and we're starting to see the wheels of commerce getting going there. In terms of the bigger, chunkier, more controlled positions, nothing right now. And hopefully, the M&A spirits will get going and we can see more activity in some of the bigger names sooner.

And we'll take a question from Paul Johnson with KBW.

Just on one specific company in the portfolio, I think it's been a while since the business came up, but it's one of your control positions, JF Intermediate, looks like the mark was pretty stable quarter-over-quarter. Could you just maybe talk a little bit like how that business, I guess, is kind of performing year-to-date? It looks like the financials, which you guys disclosed in the filing. It's not profitable on a net income basis, but maybe more so on a cash flow basis if there's a lot of depreciation in the business. But just wondering if you can kind of provide an update on how that investment is performing.

Yes. It's a good question, Paul. The company generates substantial EBITDA. This was originally a mezzanine debt position, which we rotated or was restructured into an equity position. Company is doing really well. Company is doing well. EBITDA is up and significant. EBITDA is well north of $50 million. So it's becoming a substantial company. Company executed a debt refinancing during the quarter. So last quarter, we had a debt position, a first lien loan position in the company. We were refinanced out by a club of direct lenders. So we still have the equity position. We are pleased. We got really good demand on the debt side, some really well-known direct lenders lend money to the company. And we're well set up, hopefully, in the not-too-distant future to see something on the equity. But like the company is ramping up well, we got out of our loan, and now we're just going to let the company grow and it's got some add-on acquisitions it can make. So we feel it's well set up to increasing value, hopefully and over time, turn into cash for our shareholders.

Appreciate that. And are you in the full controlling position of the equity there or you partnered with the sponsor at all?

We're partnered with an independent sponsor.

And our next question will come from Melissa Wedel with JPMorgan.

A lot of them have already been asked and answered, but I wanted to follow up on your comment about the joint venture and being able to further scale that. A similar question on the equity rotation. I'm curious how you're thinking about the time frame for fully optimizing the JV and sort of the environment that would need to exist in order to do that.

Yes. Look, we think certainly over the next probably 6 to 9 months, we can fully optimize the JV. And of course, the JV could continue, it could grow. So kind of one step at a time, we feel like we can optimize the JV fully in the next 6 to 9 months.

Okay. That's helpful. And then on the activity side of things, I'm curious if there's anything that you're anticipating on the repayment side in the near term that we should also be thinking about?

I'd say normal -- look, when there's deal activity, there's good news and there's bad news. The good news is there's new deal flow. The bad news is some of your existing deals get called out and that's typical. And that's okay. And I referenced to getting some of these equity co-investments liquid. That's typically what happens. You make the loan, you have an equity co-investment. The company gets sold, you lose the loan, the loan gets part out and you get your cash on the equity co-investment. So we're starting to see some of that as M&A resumes.

And moving on to Arren Cyganovich with Truist.

I was wondering if you could just comment on the competitive environment, always tends to be a lot of capital kind of available on the wings in the middle market these days. Anything you're seeing from either pricing pressure or you mentioned the covenants were pretty much stable in your neck of the woods. What are you seeing from a competitive environment?

Yes, it's a good question, Arren. Look, no doubt there's competition. There always is competition. It ebbs and it flows. I'd say the competition is there. It's pretty much the same players behaving in the same way that they historically behave. So generally, the competition is rational -- certainly relative to the upper market, it's a lot more rational because we're still getting covenants. We still get the monthly financial statements, we get the equity co-invest. We have time to do our diligence but it's competitive. And certainly, as deal flow comes back, we're hoping that, that will increase the supply, which by definition, may reduce competition a little bit. So -- but it's competitive out there and that's where we rely on our existing relationships, our incumbency, 190-some companies across the platform. There's such decent and good deal flow within the portfolio. A big part of our new deal opportunity is the existing portfolio as these companies grow, they need add-on loans, they need DDTL or we're in there with those sponsors. And when you're talking to the sponsors day in and day out about their portfolio, obviously, we get a good early first call and a good last look in many of the deals. So there's a lot of deal flow. We are -- we remain selective about what we put in these portfolios. I'd say we're in a pretty good spot right now.

And the next question will come from Christopher Nolan with Ladenburg Thalmann.

Art, is the -- given you have a 2026 debt maturity and given the strengthening business environment and the possibility of lower rates, is the general idea to ideally have the income from these equity rotations offset any higher coupon from refinance of the debt?

Yes. No, that's a good question. That's another variable, Chris. And by the way, Chris, welcome back to PennantPark and I want to welcome back, Arren Cyganovich also who asked the prior question back to PennantPark as a research analyst. Look, that's another variable out there is the debt maturities and what the rates are going to be at the time as we get closer to maturity. So that's a variable we have to consider. Again, we're hoping we can get some significant equity rotation, rotate the cash into yield and look at where we stand at that point in time and adjust accordingly. So -- but you're right to point that out that is a variable out there.

And just a follow-up on that note. Is using the Truist credit facility to refinance these notes a possibility, just given a lot of the talk from the administration about pressuring the Fed to reduce rates?

Yes. Look, we have a very attractive facility with Truist. We're constantly talking to them and other lenders about our liability stack. And we're trying to match our liability stack to the assets and make sure they make sense. There's different ways to fund the operations, whether it be credit facility, bonds, securitization. We do securitization well in the past, the JV. So we have a number of different tools to finance the deal flow. And we want to remain matched and prudent about the amount of leverage and the type of leverage that we put against the assets.

Our next question will come from Casey Alexander with Compass Point.

I was reading actually a summary of the transcript of the PFLT call. And there was an entry there that said merging the BDCs remains an option post equity rotation resolution in PNNT, which -- my question is that if you throw the government out of the portfolio and don't include the equity from PSLF, so the equity of PNNT is 27% of the total portfolio. For that merger to make sense, kind of what percent would you have to get that down to so that it wouldn't be highly dilutive for PFLT shareholders?

Yes. Look, I think our -- still our long-term target for equity, excluding JV equity is about 10%, which is similar to kind of where we are in the PFLT portfolio. I think it's 8% or 9%, something like that. So that will be in a more normalized. And again, I answered the question of Brian McKenna's question you asked every quarter. And I answer it the same way, which is all things are always on the table. We never say there's no options. But I said -- which I always say is we've got to -- either way, we've got to normalize the PNNT portfolio, whatever we do. So that's still the goal, and that's what we're focused on. And hopefully, we can execute on that, and then we'll come up for air and look at what we do.

My second question is, are you still doing equity co-invest? And if so, is that just exacerbating the problem or are you just doing straight debt deals now and using that to help you reduce the amount of equity in the portfolio.

So look, the equity co-invest is a deal-by-deal kind of analysis. If we do the debt, we usually get an option to look at the equity. We then analyzed the equity separately. And if it makes sense, we think as an investment, we will continue to do it. We've had a very good long-term track record as we stated. The equity heavy nature of the PNNT portfolio today is really conversions of debt to equity, not the equity co-invest portfolio, right? So equity co-invest portfolio, we're investing $1 million, $2 million, $3 million, whatever it is, as a tag has been a very strong 2x MOIC, 25%, 26% IRR over 18 years, granted sometimes the rotation is quicker. Sometimes it's slower. It's been slower recently. But it's been a good addition to all of these portfolios. But each individual equity investment needs to stand on its own 2 feet. And so far, it has. And then, again, the chunkier positions have been conversions. And on those situations, we're trying to get better. Obviously, those were debt investments that did not workout well by definition. We make mistakes from time to time, and we try to learn from those mistakes and get better and most of these chunkier positions were kind of long-standing deals that we made long ago, our underwriting track record and the last number of years have been very, very strong if you look across the platform. So it may take a little while to get some of these equity -- chunky equity positions rotated. We will do our best. That's our job as the fiduciaries for our investors, and we're going to do everything we possibly can to maximize shareholder value.

And that does conclude the question-and-answer session. I'll now turn the conference back over to Mr. Art Penn.

I want to thank everybody for their time today and listening to the story. A reminder that our next quarterly earnings is a 10-K. So we'll be reporting a little later in the quarter, probably shortly before Thanksgiving kind of mid mid-November. So look forward to speaking to folks then. And again, thank you for your time today.