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Edited Transcript of PNNT earnings conference call or presentation 8-Aug-19 3:00pm GMT

Q3 2019 PennantPark Investment Corp Earnings Call

NEW YORK Sep 2, 2019 (Thomson StreetEvents) -- Edited Transcript of PennantPark Investment Corp earnings conference call or presentation Thursday, August 8, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Arthur Howard Penn

PennantPark Investment Corporation - Founder, Chairman & CEO

* Aviv Efrat

PennantPark Investment Corporation - Treasurer & CFO

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Conference Call Participants

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* Casey Jay Alexander

Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst

* Kyle M. Joseph

Jefferies LLC, Research Division - Equity Analyst

* Michael John Ramirez

SunTrust Robinson Humphrey, Inc., Research Division - Associate

* Mickey Max Schleien

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst

* Richard Barry Shane

JP Morgan Chase & Co, Research Division - Senior Equity Analyst

* Robert James Dodd

Raymond James & Associates, Inc., Research Division - Research Analyst

* Ryan Patrick Lynch

Keefe, Bruyette, & Woods, Inc., Research Division - MD

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Presentation

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Operator [1]

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Good morning and welcome to the PennantPark Investment Corporation's Third Fiscal Quarter 2019 Earnings Conference Call. Today's conference is being recorded. (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 now begin your conference.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [2]

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Thank you, and good morning, everyone. I'd like to welcome you to PennantPark Investment Corporation's Third Fiscal Quarter 2019 Earnings Conference Call. I'm joined today by Aviv Efrat, our Chief Financial Officer. Aviv, please start off by disclosing some general conference call information and include a discussion about forward-looking statements.

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Aviv Efrat, PennantPark Investment Corporation - Treasurer & CFO [3]

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Thank you, Art. I'd like to remind everyone that today's call is being recorded. Please note that this call is a property of PennantPark Investment Corporation and that any unauthorized broadcast of this call, in any form, is strictly prohibited. Audio replay of the call is available by using the telephone numbers and PIN provided in our earnings press release 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 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.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [4]

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Thank you, Aviv. I'm going to provide an update on the business starting with financial highlights, followed by a discussion of the overall market, the portfolio, investment activity, the financials and then open it up for Q&A.

For the quarter ended June 30, 2019, we invested $116 million in primarily First Lien Secured Debt at an average yield of 10.3%.

Net investment income was $0.17 per share. NII was temporary low -- temporarily lower this past quarter as we continue to reposition the portfolio.

Remember that last quarter, we exited a large high-yielding second lien position at an attractive return.

As we have discussed, we're generally moving into first lien secured positions, higher in the capital structure and into a more diversified portfolio.

As of June 30, first lien exposure was nearly 60% of the portfolio, up from 43% a year ago.

Along with a lower risk portfolio, we intend to prudently target higher leverage. Over time, we are targeting a regulatory debt-to-equity ratio of 1.1 to 1.5x. We will not reach this target overnight. We will continue to carefully invest, and it may take us several quarters to reach this new target. A careful and prudent increase in leverage against a primarily first lien portfolio should lead to higher earnings.

We are also actively assessing other options for increased earnings, including another SBIC and the senior loan joint venture, similar to the successful joint venture that we had with PFLT. Additionally, as of last September 30, we had a taxable spillover of $0.30 per share, which provides significant dividend cushion.

Our primary business of financing middle-market sponsors has remained robust. We manage relationships with about 400 private equity sponsors across the country from our offices in New York, Los Angeles, Chicago and Houston. And we've done business with about 180 sponsors. Due to the wide funnel of deal flow that we receive relative to the size of our vehicles, we will continue to be extremely selective with our investments.

You will recall that in 2007, just as today, PNNT was focused on financing middle-market financial sponsors. Our performance through the global financial crisis and recession was solid. Prior to the onset of the global financial crisis in September 2008, we initiated investments, which ultimately aggregated $480 million.

We invested well. Average EBITDA of the underlying portfolio companies fell about 7% at the bottom of the recession.

According to Bloomberg North American High Yield Index, the average high-yield company EBITDA was down about 40% during that time frame. As a result, we had few defaults and attractive recoveries on that portfolio. The IRR of those underlying investments was 8%, even though they were done prior to the financial crisis and recession. We are proud of this downside case track record.

We've had only 13 companies going nonaccrual out of 229 investments since inception 12 years ago.

Further, we are proud that even when we've had those nonaccruals, we've been able to preserve capital for our shareholders.

As of June 30, 2019, we continue to have 1 nonaccrual, which represents 1.5% of our overall portfolio at cost and 0.7% at market.

Since inception, PNNT has made 229 investments, which totaled about $5.5 billion at an average yield of 12.1%.

This compares to an annualized loss ratio, including both realized and unrealized losses of about 30 basis points annually.

This strong track record includes both our energy investments as well as our primarily subordinated debt investments made prior to the financial crisis.

At this point in time, our underlying portfolio indicates a strong U.S. economy and no signs of a recession. We remain focused on long-term value in making investments that will perform well over an extended period of time and can withstand different business cycles.

We are a first call for middle-market financial sponsors and management teams and intermediaries who want consistent and credible capital.

As an independent provider free of conflicts or affiliations, we are a trusted financing partner for our clients.

In general, our overall portfolio is performing well. We have a cash interest coverage ratio of 2.5x and debt-to-EBITDA ratio of 4.7x at cost on our cash flow loans.

With regard to our energy exposure, there has generally been no material change since last quarter.

On a mark-to-market basis, positive movements and the value of Wheel Pros, Ram Energy and MidOcean JF were offset by valuation declines in Hollander, ETX and U.S. Well. On an overall basis, NAV was down $0.09 per share due to valuation.

In terms of new investments. We've known these particular companies for a while, have studied the industries or have a strong relationship with the sponsor.

Let's walk through some of the highlights. We purchased $20 million of the first lien term loan; $2.5 million of a revolver; and $0.5 million of preferred and common equity of MeritDirect. The company is a provider of B2B database products, Mountaingate Capital is the sponsor.

Signature Systems is a designer manufacturer of ground protection products. We purchased $15 million of a first lien term loan and $1.4 million of preferred and common equity. Center Rock Capital is the sponsor.

We purchased $8.6 million of a first lien term loan and $1.6 million of a revolver of TWS Acquisition Corporation. TWS is a for-profit provider of postsecondary education focused on technical careers and skilled trades. Halifax Group is the sponsor.

Turning to the outlook. We believe that the remainder of 2019 will be active due to growth in M&A-driven financings. Due to our strong sourcing network and client relationships, we are seeing active deal flow.

Let me now turn the call over to Aviv, our CFO, to take us through the financial results.

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Aviv Efrat, PennantPark Investment Corporation - Treasurer & CFO [5]

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Thank you, Art. For the quarter ended June 30, 2019, net investment income totaled $0.17 per share, including $0.02 per share of other income.

Looking at some of the expense categories, management fees totaled $7.1 million; general and administrative expenses totaled $1.2 million; and interest expense totaled $7.8 million.

Our investment loss of $0.08 per share on a mark-to-market basis. Our dividend exceeded our GAAP net investment income by $0.01 per share. Consequently, NAV per share went from $8.83 to $8.74 per share.

As a reminder, our entire portfolio, credit facility and senior notes are mark-to-market by our Board of Directors each quarter, using the exit price provided by independent valuation firms, security and exchanges or independent broker-dealer quotes when active markets are available under ASC 820 and 825.

In cases where broker-dealer quotes are inactive, we use independent valuation firms to value the investments.

Our overall debt portfolio had a weighted average yield of 10.1%.

On June 30, our portfolio consisted of 68 companies across 28 different industries. The portfolio was invested 59% in first lien senior secured debt, 23% in second lien secured debt; 4% in subordinated debt; and 14% in preferred and common equity. 88% of the portfolio had a floating rate.

Now let me turn the call back to Art.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [6]

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Thanks, Aviv. To conclude, we want to reiterate our mission. Our goal is to generate attractive risk-adjusted returns through income, coupled with long-term 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 conversion. We capture that free cash flow, primarily in debt 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 team of professionals for their commitment and dedication.

Thank you all for your time today and for your continued investment and confidence in us.

That concludes our remarks. At this time, I would like to open up the call to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And I'll take our first question from Kyle Joseph of Jefferies.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [2]

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Art, just stepping back and looking at things from a macro perspective. I know you talked about your credit is still stable and you're not seeing any signs of a recession. But in terms of revenue and EBITDA growth at your portfolio companies, have you seen any sort of shift as macro volatility has picked up a bit in recent months?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [3]

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That's a good question, Kyle. We just did a portfolio review internally last week. And it looks like on average, EBITDA, on average, are up 5% to 8%.

Obviously, there's some there that are doing a little bit better, some that are doing a little bit worse. And that's our latest kind of monthly snapshot. We can't predict where we are going to be 6 months from today, but we do track this stuff monthly. And based on that, we're feeling fine about the economy at this point.

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Kyle M. Joseph, Jefferies LLC, Research Division - Equity Analyst [4]

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Got it. And then, obviously, we're in kind of a new rate environment these days. Can you give us a sense for your outlook on margins, given the strategy shift on the asset side? And then also, you've recently kind of redone your balance sheet. So how it looks on the liability side if rates continue to decline?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [5]

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Asset side, it's going to be interesting as LIBOR has gone down, how much the market prices on spread versus absolute, our spreads are going to widen, or our spreads are going to stay the same, and absolute yield is going to come down. We don't have a clear picture at this point other than as far as the first lien business we're doing, it is kind of stable from a spread standpoint over LIBOR. We're not seeing any tightening. The question is are we going to see widening if people priced to an absolute yield. But at this point, spreads have not tightened but absolute yields, of course, have.

Now we move to liability side. PNNT's liabilities, at this point, are primarily floating rate, our SBIC financing is fixed rate at a very low cheap rate.

We're going to assess fixed rate. We're going to assess other options of financing over time. We talked about SBIC financing in the script, we're thinking about another joint venture like the one we did at PFLT. Maybe we think about unsecured bonds again at some point, if that's going to help us diversify our funding sources and really maximize our flexibility on the senior side.

So everything's on the table from the standpoint of the liability side in terms of how we can best optimize getting to the slightly higher leverage ratio that we're targeting. But we have not seen -- back to your question, which was have we seen spreads? Have we seen any difference in spreads or margins or yields? And at this point, we haven't. It's kind of still pricing at a spread to LIBOR.

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Operator [6]

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And I'll take the next question from Michael Ramirez from SunTrust.

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Michael John Ramirez, SunTrust Robinson Humphrey, Inc., Research Division - Associate [7]

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I guess -- so regarding a potential new senior loan JV, would you have any updates on finding the right partner? And could you please help us understand what you would like to see in regards to the contribution to both ROE and NII from the JV?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [8]

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So look, I think, first of all, on process, we're just getting going, assessing our options there. It's been a very nice partnership over at PFLT with Kemper, and that's worked very well, along with our lender, Capital One.

So we're just getting going, evaluating options from PNNT. I would think it would look pretty similar to what we're doing at PFLT, which is a very nice, steady ROE contribution to PNNT, we hope, with that kind of profile of loan within that JV. But we're just getting going.

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Michael John Ramirez, SunTrust Robinson Humphrey, Inc., Research Division - Associate [9]

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Okay. Great. That's helpful. I guess one last one if I may. So I guess -- and we've talked about this before but while we understand it to be difficult to predict. Could you give us a sense of repayment activity over the next year? And basically, especially in regards to with the prospect of lower short-term interest rate, coupled with a strong economic background -- backdrop for your portfolio companies, if there is a potential for them to sort of repay just because the company is doing better or frankly refinance their loan just because company is doing better and there is a potential for lower short-term interest rate?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [10]

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Yes. It's a good question, and something we need to spend some time thinking about. We have LIBOR floors in 90%, 95% of our loans as LIBOR floors are typically 1%. Occasionally, they're 1.5%. You may see more LIBOR floors getting structured back into deals or higher LIBOR floors for sure.

Where we tend to get refinances where companies get kind of big enough where they can access the broadly syndicated market and where they can get covenant-lite financing. And it hasn't been -- as yields or spreads have come down, that has not really been the driver of refis. It's been -- as the companies grow and we hope that they grow, they can get -- move into the BSL covenant-light world. So we don't see a wave. I don't see a wave at this point of refinancings, but we'll keep our ears to the ground.

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Operator [11]

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I'll take the next question from Ryan Lynch of Keefe, Bruyette & Woods.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [12]

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First one, I know over the last several years, you guys have been investing in the people on the platform across PennantPark, opening a few new offices and such. I was just wondering, can you kind of talk about the deal flow you guys have been seeing over last several quarters? Are you guys starting to see any sort of different deal flow from different sponsors or different areas as you guys continue to invest in the platform?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [13]

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Yes. Thanks, Ryan. Yes, we have -- started 4 years ago, we brought some very senior people into the firm who we'd worked with in prior lives, who we trusted. And we've opened up offices in Chicago, Houston, Los Angeles, and we beefed up New York. And what that has allowed us to do is really expand the number and variety of deals that we've seen as we expand the sponsor relationships.

And as I look at the highlighted deals in the script earlier, all of these transactions came from new sponsors that we didn't have relationships with a few years ago. Whether we have a Denver sponsor, a Chicago sponsor, a Dallas sponsor. I kind of highlighted in my comments a moment ago. So that's -- it's nice to the senior relationships. But as importantly or most importantly for our investors, it's about seeing more options so that we can then be highly selective about what comes into the portfolio.

So it's been a really, really positive thing for us to be increasingly selective in this market, develop these relationships and then hopefully, build up even a broader, more diversified and safer portfolio.

So we're pleased that it's come along, and the senior folks we've hired are, again, folks we worked with for a long time, and there's a lot of trust built up. When you open up a regional office, we want them to be the line of first defense and to be skeptical. Just to be clear, no one gets paid a commission at PennantPark to bring a deal in or to jam a deal through investment committee. We first want to hear why we shouldn't do a deal before we hear why we might want to. So when we hire senior people to help expand our reach, they really become our line of first defense to be able to be highly selective about what comes into the portfolio.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [14]

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That's helpful. And there's no doubt having a wider funnel is definitely a better way to execute. The question is, if you are originating deals with new sponsors that you haven't done deals with in the past, how do you get comfortable with participating in a deal with a new sponsor? I mean, when you have an existing sponsor, you know their track record. You've probably worked with them. You might have had some bumps in the road along the way. You see how they work through deals. You don't have any of that sort of background when you're taking on a new sponsor. So how do you get comfortable with that? And is there a higher bar when you guys are originating new loans with a new sponsor?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [15]

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It's a great question. And we go back to the saying, the 3 Cs of credit, cash flow, collateral and character, with character probably being the most important of the 3.

So we underwrite the people. We underwrite the sponsor. We do reference checks. We look at their past performance. We look at how they've dealt with lenders and challenging investments in the past. And information is pretty easy to come by in our world. So just like they're underwriting us, same, there's a mutual underwriting going on. We're underwriting them. They're underwriting us. And you can get to the bottom of people's reputation and their behavior pretty quickly in this world that we're in today. So it's a thorough vetting that we go through before we take on new clients.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [16]

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Okay. And then you mentioned earlier about just in the very beginning stages of exploring a potential JV similar to what you have in PFLT.

I was just curious, obviously, those sort of structures use off-balance sheet leverage so to generate an enhanced return. Currently, PNNT has a leverage target of 1.1 to 1.5. Do you guys -- how do you guys view you guys' current leverage target in conjunction within some sort of JV that uses leverage that's off balance sheet? Would you guys view that as -- obviously, that's not going to affect your regulatory leverage. But if you do any sort of look-through leverage, that obviously is increasing the leverage on a look-through basis. So does that affect you guys' view of how you view leverage?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [17]

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Sure. You have to be sensible about how you leverage. I mean we're getting smarter about the CLO world. We just talked about it on the PFLT call. They were looking at securitization technology for PFLT. And certainly, it looks like the market can comfortably finance middle-market first lien assets 4:1 or 5:1. That's not what we're aiming at here. But it seems like there's a market for that, both for debt and equity investors. So as we take what we think are going to be safe middle-market first lien loans and think about how to optimize an ROE prudently, there's certainly an opportunity with the JV, there's certainly an opportunity on balance sheet. Certainly, the SBIC financing and we're still in dialogue with the SBA on SBIC III is attractive financing as well. SBIC financing is not accounted in regulatory debt. A JV would not be counted in regulatory debt. So we're evaluating all of these options. With the thought that as we move up capital structure, as we, at this point in time for PNNT, find a safer, more diversified portfolio, what's the best way to finance and generate an attractive ROE prudently for our shareholders.

So that's -- this is all part of the mix. We're going through it right now. The JV at PFLT has worked really, really well. And we're proud of that and we're just saying that's worked really, really well, how can that be applicable to PNNT. And how can we use that type of technology to enhance and solidify ROE for PNNT shareholders.

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Operator [18]

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I'll now take our next question from Rick Shane of JPMorgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [19]

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I want to talk about dividend and incentive fees and the spillover a little bit. Our -- you talk about the $0.30 of spillover and view that as a signal for the stability of the dividend and I appreciate that. But the reality is that if you pay the dividend -- to the extent you're paying the dividend in the quarter where you don't cover it, it erodes book value -- or excuse me, NAV. I'm curious as we move forward and you're sort of in this transition period on the balance sheet, will you provide any sort of relief on the incentive or management fees to protect the -- to protect NAV outside of marks as you sort of go through that transition?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [20]

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Yes. So that's a good question, Rick, thank you. In terms of the earnings versus the dividends, we've said, we underearned the dividend $0.01 this quarter. We believe that's temporary as we transition from kind of the second lien portfolio and we had a big -- nice exit last quarter on Park. An oversized position, we got a nice exit on. We're taking those proceeds and gradually and thoughtfully, reinvesting them in first lien with higher leverage. So we view this "underearning of the dividend". It's just kind of a temporary phenomenon. With regard to the fees, as you know, as we move above 1:1 leverage, our management fee goes down from 1.5% to 1%. And we are just -- we will shortly be doing that.

So shareholders will be getting a benefit as we do move over 1:1 leverage. And as we've been talking about -- you've seen over time we just talked about on the PFLT calls, our platform gets bigger, G&A has been getting more and more optimized and down over time as our fixed cost of our finance accounting team and ops team is deployed over more vehicles, greater assets.

So as we get bigger, there'll be higher -- hopefully, will be higher ROE based on a lower fee as we go above 1:1, based on more optimized G&A and of course, having the benefit of slightly higher leverage.

So we think the underearning of the dividend is a temporary phenomenon. It's a quarter or 2 or whatever it ends up being and is worth going through this as we're going through this transitory time frame.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [21]

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Got it. But I would point out that those are all structural tailwinds, the headwind being lower base rates and the asset sensitivity of the portfolio. And so there are going to be some offsets there, if you go through that transition.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [22]

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And certainly, if yields -- if we go through a low-yield environment, which we -- a lower-yield environment, which we may go through, it's going to hurt everybody, and the incentive fee will obviously kind of be variable with that and align to that.

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Operator [23]

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I'll take our next question from Mickey Schleien from Ladenburg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [24]

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Art, clearly, I understand that by design, PNNT is a higher-risk portfolio than PFLT, and so it has about 1/3 of the portfolio in second liens and some debt. With more signs of the economy slowing, could you tell us about your investment philosophy for these investments compared to first liens? I'm particularly interested in understanding whether you look for larger companies, more equity cushions, et cetera, for second liens?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [25]

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Yes. That's a great question, Mickey. And look the -- our investment team knows that in this environment, for us to do a second lien or mezz deal, it's got to be awfully compelling. So that's first of all -- that's the message that we're giving our own people, which is, it's got to be a truly compelling transaction for us to consider doing something that's not first lien. So what does that mean? Safe and low leverage, a wonderful company, with a great growth trajectory, terrific return characteristics, good covenants. So the word that we use internally is, it's got to be compelling. So going through it all -- going through, we're not really doing much of that these days. Every once in a while something comes along where it might be an add-on to an existing credit that's doing very, very well.

We may do a little bit of second lien and mezz, but the kind of trend is, we're at about 60% first lien today. That's going to continue to go up over time as second lien and mezz rolls off, unless we find some really compelling transactions. And don't see that happening. And occasionally, we will do an add-on to an existing deal. I think this past quarter, we added a little onto DecoPac and Wheel Pro, and you can see where those equity co-invests are marked that those companies are doing very well. But those were small little add-on amounts to existing core positions.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [26]

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I understand. So we look at the existing portfolio and consider that you're really not adding much to the second lien and mezzanine buckets. Trying to gauge the risk profile in the second lien bucket. Are these generally larger borrowers? Is it -- how does the leverage compare for your second liens to your attachment versus first liens? Is there a big difference in sponsorship?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [27]

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No. I mean it's a good question. It's the same types of sponsors that we've known for a long time. If you look at, for instance, the 2 that I just mentioned, Wheel Pro now does over $100 million of EBITDA, DecoPac, I think it's doing over $40 million of EBITDA. And you can see in the equity co-invest, the trajectory of those companies has been very positive. And because they had a positive trajectory, debt-to-EBITDA is lower.

So when companies grow, that's very nice, and particularly when we have an equity co-invest, but it's nice because that reduces risk. So we're not really doing second lien and mezz with smaller companies right now, if you would ever, if we would do much of it at all.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [28]

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And the second liens that you have, did these borrowers exist in '08 and '09? In other words, could you underwrite their EBITDA with a high level of confidence in a recession? Or...

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [29]

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Well, it's a good question because I -- these particular borrowers did not, but the style of underwriting was the same, which is, companies have a real reason to be, a real reason to exist. Does anyone care if they go away? High barriers to entry, excellent management teams, reasonable growth prospects, high free cash flow, high free cash flow conversion, which will mean deleveraging and derisking. And if you look at the second lien and mezz book that we had in 2007, 2008, it was the same type of book. Again, larger borrowers in the world of the middle-market.

So same style of underwriting. But frankly, I think that's one of the reasons. Our first lien track record has been so strong, both for PNNT and PFLT is, we take a mezzanine style of underwriting approach and apply it to first lien. So if you look at our first lien track record, it's been an annualized loss of 8 basis points a year now for 8 years. If you take a look at kind of PNNT, which we'll call across the capital structure, including second lien and some mezz, it's been like 30 basis points a year. And that includes the financial crisis, the energy downturn, et cetera. So this kind of style of underwriting is the style that we use up and down the balance sheet.

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Operator [30]

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We will now take our next question from Robert Dodd from Raymond James.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [31]

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On the Hollander, could you give us -- I don't -- obviously, you've got historically a good track record of recoveries when you do have a nonaccrual, but you have that many and you have a track record of being very patient in order to get that recovery. So Hollander, obviously, it's now filed Chapter 11. You've got a dip in there. There's a debt-to-equity conversion proposal, I think, in the restructuring. I mean can you give us any outlook on what's going on? Whether the objections within the creditors or if that's likely to -- how exactly that's likely to evolve?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [32]

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Yes. So it's a good question. It's in the (inaudible) factory as we speak. So I can only give you what's public information but I can kind of give you directionally what's going on. So it's going through the bankruptcy process now. They're stalking horse bids that are being cultivated outside of the creditors. We will see where those stalking horse bids come. We'll see what the creditors to. We are not the largest lender here. There is another well-known lender larger than us who is in this, who is going to be a driver of the -- a big driver of the ultimate outcome. So that's an independent entity from us. So we have -- we can't really control them. We can control our capital. So unclear. In the coming weeks I think this process will roll through, there'll be clarity on it, where we are hugely disappointed in, obviously, the performance of this company. We think that given time, this company can have a lot of value, but we are not as much in control as we'd like to be in this particular situation. So we'll see, we'll see where it's going to play out in the bankruptcy court in the coming weeks with the stalking horse and with the other lenders. And that's all I can really tell you right now, Robert.

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Operator [33]

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I'll take our last question from Casey Alexander from Compass Point.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [34]

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Your first loan has increased to 60%. Where does the math work out that -- you know that if you increase first lien exposure, you're going to have some compression in yields. So what percentage of the portfolio would you like to get first lien to? And then what leverage ratio works when you get there?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [35]

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It's a great question. And Casey, we'd be happy to work on your model with you off-line here, later in the day or tomorrow, if you like.

So it's hard to micromanage where you're going to because we still have some second lien and mezz risk which is going to get taken out when it gets taken out. But I think that over time where this will end up being in this environment, we have today, assuming this environment stays where it is, some point the environment could change and second lien and mezz could be very attractive again. But in this environment, I think we're going to end up getting up to 70-ish percent, maybe 75%, and then you take our target leverage, regulatory leverage of 1.1 to 1.5. Obviously, if it's a more first lien portfolio, you feel more comfortable with the upper end of that range. Layer on -- I hope we can get it, another SBIC license. You can layer on a joint venture. And the G&A continuing to be optimized, the fee coming down to 1% over 1:1 debt-to-equity. You should have a very nice and hopefully safe ROE being generated for the shareholders. But we're happy to walk through a model with you later today or tomorrow, Casey.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [36]

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Okay. And on SBIC III, are you at the green light letter stage or no?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [37]

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We are not there yet. So we are still alive. We are still alive. We're still talking. So we hope to get there, no assurances. It's not done, until it's done. We've had a very nice relationship with the SBA. It's been a good track record with them and PNNT. But we're hopeful. So you can model it with the SBIC, you can model it without an SBIC and look at it both ways.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [38]

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Okay. And what's the average EBITDA of your portfolio companies right now?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [39]

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Average EBITDA is in the $25 million to $30 million range.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [40]

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Okay. And looking through and I realize, you haven't filed it, you're not having a partner. But when you think about the SLF, would the SLF have different assets in it than what resides on balance sheet at PNNT? Or would they share some commonality of assets?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [41]

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I think it'd probably be a bunch of sharing. It's something we need to debate and talk to with our partner. PFLT and its JV have a lot of overlap. So that would be our thought. But of course, it's subject to discussion with who we ultimately partner with.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [42]

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Okay. And then my last question, Aviv said that of the $0.17 of NII, $0.02 was other income. Can you tell me what sort of drove the other income in the quarter?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [43]

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It's amendment fees, it's agency fees when we bring other investors in. It was $0.02, I think. Anything -- any other color on that, Aviv?

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Aviv Efrat, PennantPark Investment Corporation - Treasurer & CFO [44]

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No. I think that's our normal other income growth run rate. It fluctuates 1, 2 or 3 each quarter. But that's nothing extraordinary in that activity during the quarter.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [45]

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It reminds me -- we think in our minds, Casey, we think about averaging $0.02 a quarter, it's by hook or by crook, it ends up being that. Sometimes it's $0.01, sometimes $0.03. But it's -- again, we can give you specific details on specific deals, where it was but it certainly was some upfront fees, I think, it was also amendment fees.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [46]

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Yes. No, that's okay. As long as there was nothing unusual onetime mission there that it's something that happens on a reasonably regular basis. That's fine.

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Operator [47]

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This concludes the question-and-answer session. Mr. Art, I'd like to turn the conference back to you.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [48]

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Great. I want to appreciate everyone's interest today and their interest in PNNT. Hope everyone has a great end of summer. A reminder that our next quarterly conference call is going to be in mid-November, little later than normal because that's our 10-K, which takes us a week or 2 extra to finalize. But we're happy to talk to folks intra-quarter if they like, and in the meantime, have a great end of summer. Thank you very much.

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Operator [49]

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That now concludes today's call. Thank you for your participation. You may now disconnect.