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PennantPark Floating: New Stock Offering

NEW YORK, NY–(Marketwired – Feb 14, 2017) – PennantPark Floating Rate Capital Ltd. (the “Company”) ( NASDAQ : PFLT ) announced that it has entered into an agreement to sell 5,000,000 shares of common stock resulting in net proceeds exclusive of offering expenses to the Company of approximately $70.4 million, or $14.08 per share. 

The Company’s investment adviser, PennantPark Investment Advisers, LLC (the “Investment Adviser”), has agreed to pay the underwriters a supplemental payment of $0.46 per share, which reflects the difference between the actual public offering price of $13.62 and the net proceeds of $14.08 per share to be received by the Company in this offering. In addition, the Investment Adviser has agreed to bear the sales load payable to the underwriters. The Company is not obligated to repay the supplemental payment and sales load paid by our Investment Adviser.

The closing of the transaction is subject to customary closing conditions and the shares are expected to be delivered on February 17, 2017. The Company also has granted the underwriters an option to purchase up to an additional 750,000 shares of common stock.

The Company expects to use the net proceeds to reduce outstanding debt obligations, to invest in new or existing portfolio companies, to capitalize a subsidiary or for other general corporate or strategic purposes.

Morgan Stanley & Co. LLC, Goldman, Sachs & Co., J.P. Morgan Securities LLC, Keefe, Bruyette & Woods, A Stifel Company, RBC Capital Markets, LLC and SunTrust Robinson Humphrey are acting as joint bookrunning underwriters. Comerica Securities, Inc., Janney Montgomery Scott LLC, JMP Securities LLC, Ladenburg Thalmann & Co. Inc. and Maxim Group LLC are acting as co-managers.

Full press release here.

BACKGROUND: Back in the quarter ended June 30, 2015, PennantPark Floating Rate (PFLT) was earning Net Investment Income Per Share of $0.28 and Net Asset Value Per Share was $14.33 on a portfolio of $359mn.

The annual distribution pace was $1.14 a year.

BIG DEAL AT THE TIME

However, in August 2015 PFLT -in a bit of a coup in the rough and tumble world of BDC M&A-acquired what remained of MCG  Capital (formerly with the ticker MCGC) and its public shareholders.

MCGC was no longer a functioning BDC at that point in the summer of 2015, given that virtually all assets were in the form of cash from a successful sell-off of the under-performing portfolio.

The External Manager-given that Cash Is King-had to pay up for MCGC, including a contribution for its own pocket.

The result, though, was that PFLT’s shareholder base grew substantially with the addition of the MCGC shareholders, as did its total assets.

GROWING UP

In the quarters that followed PFLT has been busy putting the new cash capital to work building up its portfolio.

OUR VIEW-EARLIER VERSIONS

We wrote a progress report on Seeking Alpha in November 2015, and followed up with the world’s longest comment at the time of the PFLT IVQ 2015 Conference Call.

Generally speaking, we were optimistic that PFLT-after seeing earnings per share drop dramatically from bringing in all those MCGC shareholders from the lifeboats-would be to grow its portfolio successfully and without a change in the lower yield-lower approach which has been its hallmark since its IPO.

We were less optimistic that shareholders who had been on board the HMS PennantPark Floating when the MCGC owners had been picked up would see much of a benefit from an Earnings Per Share perspective.

Moreover, we were concerned that the only way PFLT could match its earnings with the $1.14 a year distribution would be by increasing leverage to beyond the level of June 2015, just before the merger took place.

We didn’t worry too much about the External Manager who seemed almost certain to recoup any monies spent on the MCGC acquisition in a long stream of additional Management and Incentive Fees.

THE RESULTS SPEAK FOR THEMSELVES

On February 9, 2017 PFLT announced earnings for the quarter ended December 31, 2016.

Even if PFLT’s management did not say or land any jets on any aircraft carriers, the results showed Mission Accomplished.

Adjusted Net Investment Income Per Share (there’s a perfectly appropriate add-back of an Unrealized Gain on the portfolio fee involved) reached $0.285 and Net Asset Value Per Share was $14.11.

The NAV would have been higher but PFLT has been draining its previously earned but undistributed Net Investment Income balance to pay all its shareholders an unchanged $1.14  distribution through  the intervening quarters.

Total assets are now at $657mn- an 83% increase. Borrowings have exactly doubled from $156mn to $312mn.

As we expected, to achieve the feat of maintaining recurring earnings and distributions, PFLT’s debt to equity has increased from the June 2015 level, but only marginally.

CREDIT QUALITY

Most importantly of all, this growth has been achieved while avoiding any significant credit problems (knock on wood) in the past 18 months.

PFLT likes to point out that its credit performance since its IPO has been outstanding. Here’s a quote from the latest Conference Call, but a similar point is rterated at every opportunity:

Out of 286 companies in which we’ve invested, we’ve only experienced four non-accruals.

On those four non-accruals, we’ve recovered a 111 cents on the dollar so far. At December 31st, we had no non-accruals on our books. This credit performance has resulted in a 13 basis point annual net gain since inception six years ago, whereas typically there were some net loss on the credit portfolio.

WE DON’T DISAGREE

We’re not here to be cheerleaders, but the BDC Credit Reporter does review the portfolio of every BDC out there every quarter, and PFLT has been one of the very best performers since we started taking a magnifying glass to the subject in 2015.

To give some color, PFLT has been successful so far in restructuring and retaining some wayward loans. After all, with liquidity so strong in the market, there’s capital available for almost everyone.

FULL PICTURE

Less sure is if the restructured entities will continue to perform  when economic conditions change.

Moreover, the Company  still has 8 companies (out of 98 in portfolio) on our Watch List, unchanged from the prior quarter.

One Watch List company was sold out of the Watch List, but a new borrower took its place.

All in all, the Watch List investments have a fair market value of $26mn.

That’s still a very modest 6% of the equity of PFLT, after roughly adjusting for the latest secondary.

Given that most of the Watch List loans are in a senior position to substantial-if under performing-companies, even a Worst Case Scenario (our bread and butter) would have a relatively modest impact on earnings and NAV.

ONE MORE REASON YOU NEED THE BDC REPORTER

(By the way, PFLT declines to offer up a quarterly credit update on its portfolio, contrary to the practice at most BDCs).

BOOST

PFLT has also been blessed (for a BDC that’s much more of a lender than an equity investor) in having a portfolio company in which it held shares go public. (That’s rare in the middle market too).

E.L.F Beauty  has a cost just under $300K, but is valued over $3mn.

Of course-as we’ve said before “into all lives some rain must fall” and PFLT will sooner or later have to reckon with some credit losses, but the track record to date, and the current portfolio, is superior.

SHAREHOLDERS GOING NOWHERE. FAST.

What shareholders  cannot expect (and unfortunately our predictions on this subject have also proved accurate) is much hope for a higher distribution per share.

The BDC may have increased total assets, the number of companies in portfolio and the share count substantially since mid 2015, but recurring earnings per share and the distribution have not budged.

Nor is that likely to change unless a drastic change is made to the business model.  With a portfolio yielding about 8%, a low cost Revolver and the existing fee structure at virtually any size the same percentage of income drops down to shareholders.

Even operating expenses of the BDC- which you might expect to be fixed-have increased proportionately with the portfolio.

So here’s the rub: Shareholders are no better off than they were a year and a half ago and are unlikely to see any material increase if nothing changes.

THE EXTERNAL MANAGER: LET THE GOOD TIMES ROLL

On the other hand, the External Manager is already earning nearly twice as much in Management and Incentive Fees in the IVQ of 2016 as in the IIQ of 2015, and is slated to see that increase another 20% or more with the new capital raised.

(For all our calculations, we’ve excluded the capital gains fee on Unrealized Appreciation built into the IVQ 2016’s Incentive Fee).

Putting that into absolute numbers, the External Manager will be making $12.5mn plus in annual Management & Incentive Fees, up from a $6mn annualized rate in June 2015.

Or put another way: while the average shareholder has seen a zero increase in earnings per share, the External Manager will have doubled its compensation.

GENEROUS OR PRAGMATIC ?

No wonder the External Manager was prepared to pay a portion of the secondary issue costs, as described in the press release above.

Wouldn’t you throw in $2.5mn today for a stream of fee income that over 10 years is likely to earn you $125mn, plus pay your overhead and key staffing costs ?

FINGER POINTING

The key element in this unequal equation is the Incentive Fee paid to the Manager.

Ironically, as more leverage is added and the risk to shareholders increase, the amount of the Incentive Fee only grows, thanks to the counter-intuitive nature of the compensation arrangements  between BDC and Investment Advisor.

(In any other business shareholders are rewarded for successfully taking on more risk. In BDC-land, the External Manager reaps most of the benefit as higher income over the pre-determined yield threshold results in bigger fees).

Yet, should that additional risk result in a loss of capital to shareholders (those famous loan write-offs actually happening), the Investment Advisor is barely impacted. The Management Fee drops on the assets reduced in value and the Incentive Fee-may or may not-drop marginally.

TIME TO CALL A SPADE A SPADE.

So the real “winners” one and a half years after the BDC boldly took on MCGC’s assets are the External Manager and the investment banks listed above who placed the secondary.

Investors  will just have to take what’s on offer (and-ironically- this is one of the better deals out there in BDC-land).

A WORD TO THE BOARD OF PFLT

It does not have to be this way.

If PFLT’s Board was more “independent” and more  focused on improving shareholders fortunes they would have taken the annual opportunity to renegotiate the Investment Advisory Agreement, taking into account the changing economics of the BDC.

The External Manager only charges a fair 1% on investment assets. (That was established at the time of the IPO and does not come from any wrangling between External Manager and Board).

However, the Incentive Fee should have reduced  and/or changed to include a Total Return concept, which many External Managers have signed on to.

Cutting the existing Incentive Fee in half in the latest quarter would have boosted EPS by $0.07, and potentially increased the dividend by 6%.

Adding a Total Return concept would diminish shareholder losses when credit losses do occur.

This is hardly asking for the moon.

BEING REALISTIC

Unfortunately-but a surprise to no one with any familiarity with BDC corporate governance-an arm’s length negotiation between shareholders (as represented by the Board) and the External Manager does not occur in virtually any case.

Certainly, PFLT is no worse-and in many cases much better-than its BDC peers.

Nonetheless, it’s clear than in this over-heated investing environment BDC sponsors/External Managers and their investment banking advisors, can get away with keeping BDC shareholders in the same place and call it progress.

We would advise investors to Just Say No, but we’re caught up in the same net.