Good morning. Welcome to the PennantPark Floating Rate Capital's Second Fiscal Quarter 2022 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 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, 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 PennantPark Floating Rate Capital. Mr. Penn, you may begin the conference.
Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Floating Rate Capital's Second Fiscal Quarter 2022 Earnings Conference Call. I'm joined today by Richard Cheung, our Chief Financial Officer. Richard, 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. Audio replay of the call will be available by using telephone numbers and PIN provided in our earnings press releases as well as 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 take 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, Richard. I'm going to spend a few minutes discussing how we fared in the quarter ending March 31, how the portfolio was positioned for the upcoming quarters, our capital structure and liquidity, the financials, and then open it up to Q&A. From an overall perspective in this era of inflation, rising interest rates, and geopolitical risk, we believe that we are well-positioned as a senior secured first lien lender focused on the United States. The floating rates on our loans can protect against rising inflation. We are pleased to be lending into the core middle market where we are an important strategic capital for our borrowers and are not commoditized. For the quarter ending March 31, our net investment income was $0.29 per share, which includes $0.01 of other non-recurring income. Our credit quality remained solid.
With regard to the PSSL JV, with the CLO financing we completed earlier this year, as well as additional capital commitments from PFLT and Trinity, the JV will continue to grow. The capital contributions from PFLT are targeted to generate a 10%-12% return. During the quarter, we announced an increased commitment to the JV of $57 million, which puts it on the path to growing the JV to approximately $1 billion of assets over time. We believe that the increase in scale and the attractive ROE will enhance PFLT's earnings momentum. Despite the market having a relatively light overall origination volume in the quarter, PFLT grew modestly and the JV grew by 10% to a total size of $705 million. Even though the overall market was choppy, we are pleased with the resilience of our NAV.
GAAP NAV was down only $0.08 per share, and adjusted NAV, excluding the mark-to-market of our liabilities, was down only $0.02 per share. We have a long-term track record of generating value by successfully financing high-growth 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. As an aside, government services and defense is approximately 16% of the portfolio, inclusive of PSSL, and this sector should be a beneficiary of the geopolitical environment.
In many cases, we are typically part of the first institutional capital into a company where a founder, entrepreneur, or family is selling their company to a middle-market private equity firm. In these situations, there is typically a defined game plan in place with substantial equity support from the private equity firm to substantially grow the company through add-on acquisitions or organic growth. The loans that we provide are important strategic capital that fuels the growth and helps that $10 million-$20 million EBITDA company grow to $30 million, $40 million, $50 million EBITDA or more. We typically participate in the upside by making an equity co-investment. Our returns on these equity co-investments have been excellent over time.
Overall for our platform, from inception through March 31, our $324 million in equity co-investments have generated an IRR of 27% and a multiple on invested capital of 2.7x. 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 covenants, substantial equity cushions to protect our capital, attractive upfront fees and spreads, and an equity co-investment. Additionally, from a monitoring perspective, we receive monthly financial statements to help us stay on top of the companies. With regard to covenants, virtually all of our originated first lien loans have meaningful covenants which help protect our capital. This is one reason why our default rate and performance during COVID were so strong.
This sector of the market, companies with 10 million-50 million of EBITDA, is the core middle market. As we just highlighted, within the core middle market, we think our capital can add the most value and where we can get the strongest package of risk return is in the $10 million-$30 million of EBITDA range. Our track record at PennantPark has been excellent for 15 years, but it took a step up and improved as we increased our focus on this portion of the market starting in 2015. The core middle market is below the threshold and does not compete with the broadly syndicated loan market or high yield markets. As many of you know, there has been an enormous amount of capital raised by some of our large peers.
As such, they are forced to focus on the upper middle market, which are companies with over $50 million of EBITDA. Those upper middle market companies can typically also efficiently access the broadly syndicated loan market. As a result, in the upper middle market, our large peers need to aggressively compete with the broadly syndicated loan market and among themselves. This results in transactions where leverage is high, covenants are light or non-existent, spreads and upfront fees are compressed, and decisions need to be made quickly. Additionally, from a monitoring perspective, we only receive financial statements quarterly. The argument you will hear is that bigger companies are less risky. That is a perception and may make some intuitive sense, but the reality is quite 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 portfolio performance remains strong. As of March 31st, the average debt-to-EBITDA on the portfolio was 4.7x, and the average interest coverage ratio, the amount by which cash income exceeds cash interest expense, was 3.1x. This provides significant cushion to support stable investment income even as interest rates rise. These statistics are among the most conservative in the direct lending industry. As of March 31st, we had only two non-accruals out of 125 different names in PFLT and PSSL.
This represents only 2.5% of the portfolio at cost and 2.2% at market value. Our credit quality since inception over 10 years ago has been excellent. Out of 441 companies in which we have invested since inception, we've experienced only 15 non-accruals. Since inception, PFLT has invested over $4.8 billion at an average yield of 8%. This compares to a loss ratio of only 7 basis points annually. In our target market, the outlook for new loans is attractive. With our experience, talented and growing origination funnel is producing active deal flow. Let me now turn the call over to Richard, our CFO, to take us through the financial results in more detail.
Thank you, Art. For the quarter ended December 31st, net investment income was $0.29 per share, including $0.01, $0.01 per share of other income. Looking at some of the expense categories, management fees and performance-based incentive fees totaled about $5.6 million. Taxes, general, and administrative expenses totaled about $900,000 , and interest expense totaled about $6.7 million. During the quarter ended December 31st, the net realized and unrealized change on investment was a loss of $1.8 million or $0.04 per share. Net of associated tax provision. Due to our successful equity co-investment program, we had a tax provision of $3.8 million. Without that provision, our net loss of $1.8 million would have been a gain of $2 million or positive $0.05 per share.
Changes in the value of our credit facility and notes decreased NAV by $0.06 per share. Net investment income equaled our dividend. We sold 2.1 million shares this quarter through the at-the-market program above our NAV, which added another $0.02 per share. Consequently, GAAP NAV went from $12.70- $12.62 per share. Adjusted NAV, excluding the mark-to-market of our liabilities, was $12.41 per share, down from $12.43 last quarter. Our entire portfolio, our credit facility, and notes are marked to market under ASC 820 and 825. Our board of directors each quarter using exit price provided by an independent valuation firm relies on independent broker-dealer quotations when active markets are available. In cases where broker-dealer quotes are inactive, we use independent valuation firms to value our investments.
Our debt-to-equity ratio was 1.5 times, while net debt-to-equity after subtracting cash was 1.4 times. We have a strong capital structure with diversified funding sources and no near-term maturities. Our portfolio remains highly diversified with 119 companies across 46 different industries. 87% is invested in first lien senior secured debt, including 14% in PSSL, less than 1% in second lien debt, and 13% in equity, including 5% in PSSL. Our overall debt portfolio has a weighted average yield of 7.5%. 99% of the debt portfolio is floating rate and 82% has a LIBOR floor. The average LIBOR floor is 1%. Now let me turn the call back to Art.
Thanks, Richard. To conclude, we want to reiterate our mission. Our goal is a steady, stable and protected dividend stream, coupled with the preservation of capital. Everything we do is aligned to that goal. We try to find less risky middle-market companies that have high free cash flow conversions. 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. In closing, I'd like to thank our extremely talented professionals for their commitment and dedication. 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 cell phone 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 take our first question from Mickey Schleien with Ladenburg Thalmann.
Yes, good morning, Art and Richard. Hope you're well. Art, obviously we're experiencing macro headwinds that we haven't seen for a long time. You had a lot of experience in the credit market. I'd like to ask you where you see defaults heading this year and perhaps the next couple of years.
Thanks, Mickey. Good morning. Thank you for participating. You're asking a great question, which it's hard to really obviously know. We've been in a really terrific environment recently with extraordinarily low defaults. One would expect us to be, as an industry or as a sector, to be, you know, heading back to a more normalized environment. We can go through the litany of different issues that, you know, potentially are challenging the economy and companies. The direct lending industry and we ourselves at PennantPark have had much lower default rates than either leveraged loan or high yield market, which I think we all attribute to experience and hopefully knowing what to avoid and what not to avoid.
At PennantPark, we've had, you know, very limited defaults over 15 years, including through the GFC, the global financial crisis, the industrial and energy downturn in the mid-teens and most recently the pandemic. I'd say the industry overall or the world overall is probably going to end up being a more normalized default, you know, experience. We're going to be something like 2%, 3% a year. You know, I think our industry is gonna be, you know, probably better than that because I think we've got some very talented managers in our sector.
That's helpful, Art. In terms of any warning signs ahead of, you know, defaults, which as you mentioned, they really can only go up from where we are. You know, with inflation running as high as it is, what trends are you seeing in your borrowers' revenues and their pricing power? And, you know, perhaps more importantly, their ability to defend their margins and service their debt.
Yeah. Look, as we stated in the comments a few minutes ago, on average, our companies are covering their interest, you know, kind of three times or so. There's a lot of cushion in there for potential rising rates and potential rising interest expense from floating rates. We and many of our peers really are focused on companies that have high EBITDA margins, which tend to indicate the companies are adding a lot of value. You know, they can raise prices on their customers relatively easily. They've got reasonable control over their supply chains in this environment. You know, we're always asking the question in the investment committee, if this company goes away, does anybody really care? Who really cares about this company? If so, what does it mean to their margins?
What does it mean to their ability to raise prices? What does it mean to their ability to manage their costs? You know, I think our average EBITDA margin in the portfolio is something like 25%, which really indicates these are high value-added companies that do by and large have control of their costs. Of course, there's going to be outliers in any portfolio. We have over 100 names, which we have nearly 119 names. Of course, there's going to be some weaker performers who are having some challenges. You know, based on the numbers we've seen, by and large, the companies are performing very well so far.
That's really interesting and helpful, Art. My last question is just in terms of you know, when we consider how steep the forward curve is for interest rates, implying that you know, risk-free rates are going to climb very meaningfully, and then we add spreads to that. You know, when do you think borrowers will begin to push back? I mean, we've got this push and pull. Lenders may be thinking about their investments in terms of adequate risk-adjusted returns, and borrowers are looking at you know, climbing coupons. Do you think the market or the private lending market will be able to maintain spreads, or are they going to give back some and look at things more on an IRR basis?
Yeah. It's hard to say. I think one of the bigger things that may happen here, you know, kind of enterprise value multiples have been at or near historical highs. You know, it used to be unusual that a company would get sold for double-digit EBITDA multiple. You know, 10 times EBITDA used to be a very high enterprise value. Now that's kind of pedestrian. There's many companies that are getting bought and sold at 14 times, 15 times, 20 times. And, you know, kind of as the risk-free rate goes up, one would think that gravity would start to take hold, and some of these higher multiples would end up coming down to earth a little bit. You know, what does that mean for us as a lender? You know, it's a good question.
I mean, PFLT, you know, we've kind of been in the mid-4x EBITDA for a long time. You know, we haven't really, you know, chased it, just constitutionally when EBITDA goes above 5x, we become a little bit more skittish. We have to have more conviction if we're gonna go above 5x. We've managed to keep our focus, you know, on capital preservation, focusing on cash flow and free cash flow. You know, we haven't really been active in the ARR software world where it's been successful to date, but we're still, you know, good old cash flow lenders.
A part of it is we're staying in a part of the market where you can do that, where our capital is not commoditized, where we are a strategic lending partner to these growing companies, where we're part of the first institutional capital, along with the private equity sponsor. There's a real game plan to take that $10 million or $20 million EBITDA company and grow it, and our debt capital is strategic to that. Part of it is the place in the market where we are, where there's, you know, less competition, where our capital is not commoditized, and where we become a real strategic partner, you know, in the deal. By doing that, we can keep these reasonable multiples. We can get covenants. We have time to do our due diligence.
We get monthly financial statements, and the package remains, you know, very attractive.
I understand. Thanks for that explanation, Art. That's it for me this morning. Talk to you next quarter. Bye.
Thank you, Mickey.
We'll take our next question from Ryan Lynch with KBW.
Hey, good morning, Art and Richard. First question has to do with just what does the environment look like as far as portfolio activity or market activity, kind of that core middle market? Obviously, there's a lot of uncertainties out in the marketplace today that you know, sponsors are looking at you know, before they transact. I'm just curious, does it look like they're able to get over those uncertainties and you're seeing capital formation and deployment, which will then create you know, deal opportunities for you? Or is it still you know, a little bit lighter than we've seen in the past? Obviously, Q1, calendar Q1 was pretty light. Just curious what it looks like so far in Q2.
That's right, Ryan. Q1 was very light. Q2 is picking up. We are getting busier. We're not, you know, 2021 was kind of an anomaly that was ridiculously busy, and I think everyone was exhausted by the end of 2021. In some ways, it was good that we had a mellow 2022, so we could all catch our breath a little bit. I'd say we're coming back to more normalized, you know, levels of activity. Is it gonna be 2019 levels? I'd say that's still probably the base case, kind of think about 2019 in terms of activity levels, pre-COVID. I'd still say that's probably the, you know, kind of rough estimate that we have for 2022. So we're busy. We're not extraordinarily busy, but we're busy.
Again, given where we are in the ecosystem of kind of part of the first institutional capital with growth plans, you know, the great thing about our economy here in America and how it operates is there's always interesting companies that are being created. There's always interesting companies where the next generation of ownership and management need to come in and take it to the next level. So there's always industrial logic, you know. Now, will that platform company sell for 10x EBITDA or 8x EBITDA? You know, that's a question. With higher risk-free rates or what's the targeted IRR for the equity? But there's always something going on. There's always, you know, there's a dynamic economy that we're privileged to be able to front row seat on.
Every day, we're seeing, you know, new kinds of companies and industries and we have an opportunity to learn and to see what's going on in the economy and help be a value-added capital provider we feel very right. So there's always something going on down where we are, you know, kind of most of it's 10-30 of EBITDA. So there's always new things that we're learning and seeing. You know, kind of back to your question, what does that actually mean in terms of origination flow? I think you kind of got to think about it as 2019 type levels.
Okay, great. That's helpful and makes sense. The other question I had is kind of a similar follow-up on Mickey's question, maybe a little bit more directly. Are you seeing any pressure yet, for the deals that you guys are negotiating today and spreads on those deals just given, you know, where LIBOR is so far today and where those forward rates are? Have you started seeing any pressure on those spreads yet?
Spread pressure. The answer is we're not seeing a lot of movement over the last couple months. You know, kind of we'll see where the more liquid markets go, broadly syndicated and high yield equity and middle market does take its cue. It may take a while to get to the middle market. You know, most important thing for us is, you know, the quality of the company, the quality of the borrower, the package of risk return that we're getting. You know, in PFLT specifically, we've always valued safety over grabbing for the extra yield. You know, we're happy to get the upside through the equity co-invest. You know, we haven't seen much change so far in the middle market. Core middle market.
Okay. Understood. Last question I had. In your prepared comments, you gave some good historical statistics on your equity co-investment program, which has been, you know, a very successful, you know, part of your platform over the years. I'm just curious, does the broader economic environment, whether that be some of the economic uncertainties that are out there or things like, you know, the trajectory of rising rates and the potential impact that that has on equity valuations, affect your guys' willingness to deploy capital or how aggressive you wanna be in that equity co-investment program? Is that purely just based on you looking at, you know, a bottoms-up at specific individual company and that outlook and whether that's a good business you think should be in or not?
Yeah. You know, I'd say we're more focused on entry multiple and potential growth of the company. We may be fine lending to a company at 4.5x EBITDA. Do we wanna do that equity co-investment at 15x?
Mm-hmm.
Maybe not, right? It may depend on what we think the growth trajectory of the company is. Would we be more apt to make that equity co-investment at 8x? Sure. That's an easier, you know, it's an easier equity co-investment. Or are you creating the equity over time at 8x? You might be buying your initial platform at a higher multiple, but because the add-on acquisitions are lower multiples, the overall multiple might be lower. We are bottoms up approach. We mesh that in with just, you know, being good old value investors and what's the value. Look, as I just said a few minutes ago, with the risk-free rate rising, inevitably exit multiples may come down, right?
Exit multiples may come down, and we have to model for that in our initial underwriting and assume, you know, you know, kind of lower exit multiples. If it meets our threshold and we think we're gonna get a 20% IRR or so, you know, we're happy to do the co-invest. If it doesn't, that's okay. We'll catch it on the next one. You know, we don't feel we never wanna put ourselves in a position where we feel pressure to deploy. You know, we want every investment to stand on its own two feet in a relaxed fashion and not kind of be forced to kind of, you know, put the money out there. I think that's one of the reasons that the fund has been strong over such a long period of time since.
Gotcha. Okay, that's helpful color . I appreciate the time for me.
Thank you.
As a reminder, if you would like to ask a question, please press star 1 at this time. Again, that is star 1 for questions. We'll go to our next question from Kevin Fultz with JMP Securities.
Hi, good morning, Art and Richard. The first question, dividend income from controlled investments was $3.9 million for the quarter. I know the majority of that was dividend income from PSSL, but can you break out the other source of dividend income there and whether those are recurring or one-time in nature? Thanks.
Richard, do you wanna handle that one? Was that all PSSL or was there anything else in there?
No, that's right. It's all from PSSL. That, the whole $3.9 million.
Okay.
That's revenue, guys, recurring and hopefully growing.
Okay, that's good to hear. My follow-up question, one of your strategies to grow NII is equity portfolio rotation. As of quarter end, the equity portfolio was about 8.7% of the total portfolio. Can you just remind us where your long-term target is for that bucket or what it is? Also general expectations for the timing of that rotation, and if that has changed at all with increased market volatility.
Yeah. You know, I think equity, we kind of target to be in this portfolio up to 10% of the portfolio, on a cost basis. You know, we're well within that on a mark-to-market basis. It obviously, it's hard for us to ever predict, you know, exit. There is some government services defense in there that's a hot sector now. It should be. That's a question in these kind of strong sectors. Do you exit now or do you wait a little bit and let them mature a little bit? You know, we are one of the few direct lenders that is highly involved in that space. It's kind of probably 15% of our overall platform across the various, you know, vehicles we have.
You might see some continued upward lift in the mark-to-market in those deals. The question is, you know, for the sponsor, we're not in control in most cases. Does the sponsor sell now or do you let this positive trend, you know, kind of go for a little while? Hard to say. You can see some clear winners in that portfolio when you look at the cost versus the mark-to-market. That's a challenge that, you know, owners of company sponsors have today with even companies doing so well. Do you really wanna sell? Do you just wanna ride for a little while? You know, I'm not giving you a real answer to that.
We obviously don't really know when these exits are gonna happen, but we're kind of well within that kind of 5%-10% range, you know, in that portfolio of equity co-invest.
Okay, that makes sense. Thanks for taking my questions.
Thank you.
With today's question and answer session, Mr. Penn, at this time, I'll turn the conference back to you for any additional or closing remarks.
I just wanna thank everybody for being on the line today and your interest in PFLT, and we will talk to you next in early August after our next quarterly earnings. Thank you very much and have a great day.
That concludes today's call. Thank you for your participation. You may now disconnect.