Summary
- PennantPark Floating Rate Capital had been on my watchlist for quite some time; I finally took a position recently.
- The business development company sold off after a share offering, right as the shares popped just a bit into premium territory.
- With higher interest rates and some more to go, BDCs can offer a place to put capital to work.
Written by Nick Ackerman. This article was originally published to members of Cash Builder Opportunities on February 16th, 2023.
PennantPark Floating Rate Capital ( PFLT ) is a business development company ("BDC") that provides investment in first-lien loans to middle-market companies. This makes it one of the more straightforward BDCs to consider investing in. They are naturally sheltered from higher interest rates by investing in floating-rate investments. In fact, higher interest rates can only stand to benefit them. We've seen some of that benefit with a recent dividend boost.
It currently trades at a slight discount to its net asset value per share, which came about from a recently conducted share offering . That's what saw this name go from a slight premium, which is admittedly fairly rare, back down to the discount level.
However, share offerings aren't the end of the world; they can often create these sorts of short-term opportunities. That's exactly what I took advantage of by adding this position to my portfolio recently. With BDCs, they pay out most of their earnings, so it's one of the only ways to grow since they can't retain earnings for growth like a traditional C-Corp operation.
About PFLT
This BDC describes itself as providing:
"primarily first lien debt. PFLT invests in middle market companies located primarily in the U.S., with a proven management team, competitive market positions, strong cash flow, growth potential, and viable exit strategies."
PFLT is externally managed, and that generally means it trades at a lower valuation due to potential conflicts of interest. The conflict of interest could arise from the management team also operating other BDCs or funds. If a good deal comes up, they might be conflicted on which investment pool to participate with if they are limited. If one fund is paying them a higher fee, the management might be more incentivized to put greater focus on that one instead.
Ultimately, I wouldn't expect this name to ever trade at a premium for extended periods of time - as history suggests to us, anyway. However, what we can often see are shares trading right near parity with their NAV. This suggests that the current level isn't an expensive time to consider putting some capital to work, leaving the door open for additional adds at better levels. While there have been periods of deeper discounts present, these were in times of heavy economic uncertainty.
PFLT Discount/Premium History (CEFData)
NAV was last reported at $11.30 . A decline from a year ago of $12.70 and also a decline from the prior quarter of $11.62 . The NAV declines are primarily related to unrealized depreciation. In the last quarter, this was roughly $16.8 million or $0.34 per share.
PFLT Statements of Changes in Net Assets (PennantPark)
Interest Rate Risks And Benefits
Like any investment, there are specific risks to BDCs that need to be considered. While interest rate sensitivity is one of their benefits - as they can benefit from higher interest rates - it can also work the other way. Lower interest rates could see declining income. Since we've been experiencing higher interest rates, this has been a tailwind for the last year.
PFLT Impact of Interest Rate Changes (PennantPark)
Additionally, at some point, the interest rate level can become too high. By investing in relatively smaller and less financially stable companies, higher interest rates mean more of their cash flows will cover their debt. This was actually touched on in their last earnings call .
An analyst asked what types of interest rates were being negotiated now that we are in a higher interest rate environment. Art Penn provided some helpful color in not only what they are seeing for rates but also the importance of interest coverage for these underlying companies they are providing loans for.
Well, the new deals that are coming in, just to give you a sense, on the senior side, a year ago, we might have been LIBOR or SOFR [575] [ph], you know 4.5x debt-to-EBITDA. And today, we're more like LIBOR, SOFR 650, maybe 700, maybe for the static quota for the actual deals we did was under 4x debt-to-EBITDA, but call it 4x debt-to-EBITDA...
...And the thing you got to look at is obviously interest coverage. The interest coverage statistic is because we're getting now 11%, 12% versus 7%, 8%, interest coverage credit stat is one that we all need to look at more carefully and make sure that the companies are in [good stead] [ph] as the types of companies we finance typically are more services businesses with low CapEx, working capital that's not that high.
NII And The Raised Dividend
We saw above how higher rates should translate into high-interest income net of interest expenses. That's because the underlying loans are mostly floating rates, and at the same time, they carry some of their leverage through fixed rates. Though it should be noted that they are less protected against higher rates on the leverage side of the equation relative to some other BDCs.
They generally expect that "...at least 80% of the value of our managed assets will be invested in floating rate loans and other investments bearing a variable rate of interest " However, this is often much higher, and 100% of their debt portfolio was invested in floating rates. They carry some equity exposure, so naturally, that isn't going to have an interest rate attached to it.
At the end of 2022, they listed $199.7 million in outstanding debt from their credit facility. A credit facility does present them with greater flexibility in terms of borrowings, but it is also done so at the cost of floating interest rates. At the end of 2022, the weighted average interest rate came to 6.5%.
They also had 2023 Notes with $76.2 million outstanding at the end of 2022, paying 4.3%. These notes will be completely repaid on December 15th, 2023. They have 2026 Notes of $185 million with a 4.25% rate.
On top of this, they then have 2031 Asset-Backed Debt. Their interest rates on these are variable and split up into different classes. At the end of 2022, the balance stood at $228 million, and the weighted average interest rate was 5.9%.
To sum up, PennantPark Floating Rate Capital is carrying $427.7 million in borrowings based on floating rates and another $261.2 in fixed. Although, the 2023 Notes are set to be lost by the end of the year. The weighted average yield on debt investments for the quarter ended was 11.3%. As long as leverage costs remain below those levels, there is still a net benefit to carrying these liabilities.
Having a heavier allocation to floating rate debt does put them in a position where they haven't benefited as much as some other BDCs. Despite that, the last rolling four quarters provided NII of $1.17, with the previous comparable period at $1.10.
The latest NII was reported at $0.30. That put them in a position to raise their monthly dividend from the $0.095 it had been for years to an even $0.10 per month. However, it does mean that currently, NII coverage of the dividend is right at 100%. They've never had a lot of flexibility or wiggle room in coverage, so this isn't a drastic change.
PFLT Distribution History (Seeking Alpha)
We are looking at a double-digit yield of nearly 11% at the current trading price. For high-yield-focused income investors, that's certainly quite appealing.
Diversification Matters
In the latest quarter, they had another company join the non-accrual list. That brought it up to three companies in total. However, that only reflects 1.9% of their overall portfolio on a cost and a fair value of 0.6%.
PennantPark Floating Rate Capital listed that their portfolio consists of 126 different companies with an average investment size of $9.1 million. By having over one hundred companies, they are involved. Each one becomes less of a concern as it comprises a smaller portion of their portfolio. Being first-lien senior secured debt also means that any default or bankruptcy could mean a high recovery rate for PFLT.
In fact, this was another interesting part of the latest conference call , where they specifically called out middle-market investments as being safer, at least according to history.
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 our performance during COVID was so strong and why we believe we are well-positioned in this environment. This sector of the market, companies with 10 million to 50 million of EBITDA is the core middle market. The core middle market is below the threshold and does not compete with a broadly syndicated loan or high yield markets.
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 has been an important part of this differentiated performance.
Being diversified across various companies also means being diversified across industries. They don't focus on any specific industry over another. Instead, they provide exposure to a broad array to help diversify their portfolio further.
There are more industries listed than this, but it gives a good sense of the type of diversification we can get with PFLT. The majority of the industries come to a 1% allocation after these are listed.
PFLT Industry Exposure (PennantPark)
Conclusion
PennantPark Floating Rate Capital has sold off a bit due to a share offering. That pushed it down from its slight premium to a discount again. A discount isn't anything new to this BDC, but I believe the current level presents a buying opportunity. That's what I did recently as I shifted this name from my watchlist to my portfolio. The recent dividend raise was a vote of confidence from the management team that PennantPark Floating Rate Capital can continue to operate well or even better in this type of environment.
For further details see:
PennantPark Floating Rate Capital: Double-Digit Yield From This BDC