Why We Bought PennantPark Floating Rate
On October 25, 2017 PennantPark Floating Rate (PFLT) priced a secondary stock offering of 6mn shares at $14.06 a share. That was just $0.01 higher than the June 2017 Net Asset Value Per Share. PFLT’s stock price dropped to a low of $13.86 following the news of the new issue. We purchased a position as part of our Long Term Income strategy for a BDC portfolio which is a mix of the three strategies we employ (Long Term Income, Special Situation and Fixed Income). See our Investment Watch Lists Table in the box on the front page of the BDC Reporter website.
THE REASONS WHY
Here is why we bought PFLT at this time:
- The BDC Is On Our Long Term Income Prospect List: The BDC Reporter tracks all 46 public BDCs out there. We’ve looked at every entity individually and determined which entities are most likely to have the lowest dividend and NAV erosion over the next 5 years. We review the risk profile of the portfolio; the use of leverage[ the credit underwriting history; the dividend policy and assess the business model – amongst other items. We also look for BDCs with a certain longevity in the market (typically 5 years at least) and where the senior management’s approach to business and investor relations seems “reasonable”. Admittedly that’s a very “soft” criterion, but much of the damage caused to BDC shareholder performance in recent years has come from internal and external managers – with very few checks and balances to be concerned about – taking unreasonable self serving and/or reckless actions. At time of writing, the BDC Reporter has identified just 15 BDCs (or a third of the universe) that meet our criteria, including PFLT.
The mid-market oriented BDC has been public since 2011. At June 30 2017, PFLT had just slightly less than $700mn in investment assets and $52mn in equity capital at par with an average cost of $13.90. The latest NAV Per Share is $14.05, buoyed by an aggregate Realized Gain on investments. As management boasted on the last Conference Call, PFLT has invested in 300 companies over the last 5 years and faced only 5 non-accruals and recovered $1.05 for ever $1.0 invested therein. On an aggregate basis , PFLT has achieved positive Realized And Unrealized Gains in its time as a public company.
The BDC has never had to reduce its dividend and has paid the same monthly distribution of $0.095 a month, or $1.080 annually for the past 10 quarters. Although the BDC Reporter is not a great fan of the technique of holding back income earned in a virtual savings account, the BDC has $0.38 per share of this “spillover” income at June 2017. This provides management some latitude to maintain the current dividend when quarterly income per share drops due to developments like a new round of share issuance.
PFLT’s business model is to focus almost exclusively on lower yielding loans , which are somewhat safer from a credit perspective within the context of non-investment grade borrowing. Excluding the BDC’s investment in a JV, only 1% of investment assets are in non-yielding securities such as equity. A critical policy of the BDC which the BDC Reporter favors is a highly diversified portfolio. Unlike some BDC managers who favor owning a smaller portfolio of loans, PFLT’s approach is be as “granular” as possible. This reduces the impact of the inevitable slip ups in credit underwriting that must happen to any lender.
Also critical to the business model is keeping costs low commensurate with the lower income achieved from targeting the less risky credits. In this regard, PFLT charges one of the lowest management fees in the public BDC space (1.0% on assets); borrows exclusively on its Revolver at a decent rate of LIBOR + 200%. Unlike many other BDCs, PFLT has avoided funding its asset growth with expensive and non-accretive unsecured notes.
We’re less enthusiastic about the Incentive Fee, which does not include a Total Return feature and allows the External Manager to count in income PIK and other non-cash income that may not be collected in the long run. Even so, the 50% catch-up provision in the calculation is more generous than in some other BDC arrangements. Overall, the “contribution margin”, as we call the percentage of investment income that drops to the Net Investment Income line and ultimately inures to shareholders (more or less), is on the high side by BDC standards.
Finally, the BDC is externally managed by PennantPark – a smaller asset management firm which sponsors two BDCs: PFLT and Pennant Park Investment (PNNT). CEO Arthur Penn has made a few mis-steps along the way (PNNT bet heavily on energy loans and funded itself partly with those infamous expensive Baby Bonds, but has reversed course on both, which is reassuring in a rear view mirror way). The Investment Advisor, thanks to the firepower of PFLT and its JV with a subsidiary of Kemper Insurance and a private fundsunder its control, is able to increasingly originate and underwrite in the middle market segment, which is a little less price competitive than the upper middle market where CLOs are more active, placing pressure on prices and structures.
2. We expect IIIQ 2017 Results To Be Good: Of course, one never knows for sure but the BDC Reporter expects the soon-to-be announced results for the third quarter to be favorable. That will provide PFLT with some breathing room to deploy the new capital being raised right now. The BDC – as part of its disclosures surrounding the secondary – announced the IIQ 2017 Net Investment Income Per Share would be between $0.30-$0.33 a share (versus $0.25 in the IIQ), boosted by the net impact of a litigation settlement left over from a portfolio company inherited from its acquisition of MCG Capital. Even net of the $0.07 a share litigation gain, that still suggests “recurring income” is running neck and neck with the prior quarter.
What the Prospectus does not tell us is what’s specifically happening to the value of the portfolio (see below) but PFLT did estimate NAV Per Share would end up increasing slightly in the IIIQ ($14.08-$14.11 versus $14.05 as of June 2017).
3. Current Portfolio Credit Quality Is Good. The BDC Reporter puts its credit hat on regularly and reviews every loan in a BDC’s portfolio. We’ve been reviewing PFLT regularly for several quarters. As of June 2017, there were 7 companies out of 86 on the books which were under-performing. We won’t go into all the details here, but we noted only 1 non-accruing loan (Sunshine Oilsands), a Hong Kong based Canadian oil sands play ! Most of the other Watch List names could yet have problems down the road but all but one had the BDC Credit Reporter’s Credit Rating of 3, where we expect that the chances of full recovery are higher than of eventual loss. Still, we’ll be looking out for updates on Charming Charlie, LLC – a company whose debt is owned by several BDCs and which is a mall retailer of women’s accessories. The company has been a great success story over the years but gast growth and that infamous sea change in consumer buying patterns could yet wreak some havoc. The rating agencies have not ruled out a restructuring coming down the pike. However, PFLT is in a senior secured position and should avoid to much damage even in a Worst Case.
We’ll be looking for valuation changes at Hunter Defense Technologies (a recently restructured credit which caused Realized Losses to some prior lenders), LifeCare Holdings, New Trident Holdcorp and Tensar Corporation. Although non-income producing, we are skeptical about the future value of Affinion Group Holdings equity owned by PFLT, but any write-down there might be offset by equity in Unitek Global Services.
No BDC – whatever management tells you – is devoid of “problem credits” and PFLT is no exception to that rule, which still seems to surprise some investors in the sector. Nonetheless, after reviewing the portfolios of many BDCs and the changes underway in PFLT’s own large group of borrowers, we did not find enough potential trouble spots to justify staying away.
4. Joint Venture Will Absorb New Capital And Boost Overall Yield. We’ve mentioned the JV with Kemper, via its subsidiary Trinity, above. We expect that the JV -which only had 14 borrowers and $75mn in assets – will be the destination for some of the additional capital PFLT has raised in the coming quarters. To date, PFLT has invested $36mn of equity and subordinated debt in the structure, but has committed to invest as much as $85mn. Once the JV ramps up – which will take a few quarters – management expects to achieve a double digit return in the “low to mid teens”. A second JV was already being mooted on the last CC.
Generally speaking, the BDC Reporter has a dour attitude towards JVs, which we see as a semi disguised way for BDCs to skirt the investor friendly 2:1 assets to debt leverage rules baked into the BDC model. However, there is no other way for the PFLT model – with its low yielding investments – to generate a decent rate of return on equity but by strategies like this. We take some comfort from the portfolio composition of the JV portfolio, which is even more “conservative” than PFLT’s main balance sheet. At the moment the JV is only booking senior secured loans (no second lien, no equity) and has a structure where capital from PFLT and Trinity can be paid in kind if portfolio value gets into trouble. This flexibility might serve the JV well during the Next Recession. However, in the medium term – as the JV leverages up with a third party senior lender- we expect both PFLT’s equity investment and its return on equity – to increase.
We’re guessing that PFLT is following a game plan that BDCs like Goldman Sachs BDC (GSBD) and others have been following of late: using the JV as the principal vehicle for asset growth. The higher yield achieved by the use of high leverage in the JV will boost PFLT’s income and overall portfolio yield, while keeping debt to equity metrics looking good and increasing incentive-fee receiving Net Investment Income. (We’re not counting on this but if PFLT ever stirred up the investor enthusiasm that GSBD – which trades at a 22% premium to book – the stock price would jump over $17 a share. By the way GSBD is also on our Long Term Income Watch List).
5. The Price Was Right. PFLT’s historic performance and lower credit risk profile is hardly unrecognized by the market. For most of 2017, the BDC has traded at $14.00 or higher, and mostly above book value as the chart shows. However, with the secondary announcement, which overlapped with the recent and still ongoing weakness in BDC stock prices, we had the opportunity to buy PFLT at close to a 6 month low. At our $13.92 purchase price, PFLT was at a (5%) discount to the 52 Week High, and at a modest discount to the projected NAV Per Share. We’re not getting PFLT at our pre-determined Fair Market Value price of $11.20, but we are concerned that we might have to wait too long to grab PFLT as cheaply as that. PFLT only traded at $11.20 or below during the few weeks before and after the BDC sector implosion of February 2016.Already a Member? Log In
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