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Edited Transcript of PNNT earnings conference call or presentation 22-Nov-19 3:00pm GMT

Q4 2019 PennantPark Investment Corp Earnings Call

NEW YORK Nov 29, 2019 (Thomson StreetEvents) -- Edited Transcript of PennantPark Investment Corp earnings conference call or presentation Friday, November 22, 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

* David Brian Miyazaki

Confluence Investment Management LLC - SVP and Portfolio Manager

* 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 Fourth 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 at PennantPark Investment Corporation. Mr. Penn, you may 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 Fourth 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 will be 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 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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Thanks, 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 September 30, 2019, we invested $39 million in primarily first-lien secured debt at an average yield of 8.4%. Core net investment income was $0.17 per share. As we have discussed, we are generally moving into first-lien secured positions, higher in the capital structure and into a more diversified portfolio. As of September 30, first-lien exposure was 57% of the portfolio, up from 47% a year ago. Along with a lower risk profile 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 the new target. A careful and prudent increase in leverage against primarily first-lien assets should lead to higher earnings. Our investment activity during the past quarter was temporarily lighter than normal because our credit facility had not yet been updated for the new BDC leverage guidelines. As such, our focus in the quarter was primarily on the right-hand side of the balance sheet.

We are pleased that in early September, we amended the credit facility, enabling us to use the incremental flexibility provided by the new guidelines. Additionally, at the end of September and in early October, we completed an $86 million offering of 5.5% unsecured notes.

In early October, we also received the greenlight for our SBIC III. We are extremely gratified that our long-term track record and excellent relationship with the SBA will result in attractively priced long-term financing for the company. We are also actively assessing a new senior loan joint venture, similar to the successful joint venture of PFLT, which can also increase earnings over time.

Since our credit facility amendment in early September, origination levels have normalized, and since September 30, we've originated approximately $70 million of new investments. The combination of the amended credit facility, unsecured bonds, SBIC III and a potential joint venture should provide a solid pathway for earnings growth at the company.

As of September 30, we have taxable spillover of $0.34 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 almost 185 different 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. The investments performed well. Average EBITDA of the underlying portfolio companies fell about 7% at the bottom of the recession. According to the Bloomberg's 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 232 investments since inception over 12 years ago. Further, we are pleased that even when we have had those nonaccruals, we've been able to preserve capital for shareholders. As of September 30, 2019, we had no nonaccruals.

Since inception, PNNT has invested in about $5.5 billion of assets at an average yield of 12.1%. This compares to an annualized loss ratio, including both realized and unrealized losses, of approximately 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 and 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, management teams and intermediaries who want consistent 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 2.6x and a debt-to-EBITDA ratio of 4.8x at cost on our cash flow loans.

With regard to our energy exposure as of September 30, there has generally been no material change. On a mark-to-market basis, positive movements in the value of PT Network and MidOcean J&F were offset by valuation declines in Hollander and ETX. Hollander was written off during the quarter.

As discussed last quarter, Hollander filed Chapter 11 in May. Our preferred strategy was a lender-funded reorganization, whereby the lenders would take majority control. Unfortunately, we could not get the majority of lenders to support a lender-funded transaction and the company was sold to a third party.

Overall asset appreciation generated $0.04 per share of NAV gain. 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. We've purchased first-lien revolver delayed draw and common equity of Altamira Technologies. The company is a government services contractor focusing on the modernization of technology for the U.S. defense and intelligence communities. ClearSky is the sponsor. We purchased $15 million of the first lien term loan of Quantum Spatial. Quantum Spatial is a provider of geospatial solutions and the company gathers detailed mapping datasets, provide analyses and generates insights for its customers. Arlington Capital is the sponsor. We've purchased first-lien revolver and equity of Schlesinger Global. The company is a global market research platform that offers agencies and brands both qualitative and quantitative data collection services. Gauge Capital 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 September 30, 2019, core net investment income totaled $0.17 per share. We also had a onetime $0.03 per share expense net of incentive fees due to the renewal of our credit facility.

Looking at some of the expense categories: management fees totaled $4.5 million; general and administrative expenses totaled $1.2 million; and interest expense totaled $7.8 million, excluding a onetime $4.4 million charge. Our investments gained $0.04 per share on a mark-to-market basis. Our dividend exceeded our GAAP net investment income by $0.04 per share, and our liability lost $0.06 per share on a mark-to-market basis primarily due to the mark-to-market of our amended credit facility. Consequently, NAV went from $8.74 per share to $8.68 per share.

During the quarter, we have also issued $75 million of unsecured bonds trading on Nasdaq under the ticker PNNTG. We are not marking to market these bonds as the SEC staff has indicated they prefer this position for the regulatory asset coverage test. We are amortizing onetime costs of $2.7 million over 4.5 years. Subsequent to quarter end, the greenshoe option was exercised for another $11.3 million, bringing the total bond amount to $86.3 million. Our regulatory leverage has increased to 0.9% -- 0.9x on NAV from 0.5x a year ago.

As a reminder, our entire portfolio, credit facility and senior notes are marked-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 quote 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 has a weighted average yield of 9.8%. On September 30, our portfolio consisted of 67 companies across 27 different industries. The portfolio was invested 57% in first-lien senior secured debt, 22% in second-lien secured debt, 5% in subordinated debt and 16% in preferred and common equity. 87% 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 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) We'll now take a question from Robert Dodd with Raymond James.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

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Just -- I mean obviously you laid out a number of steps out between the SBIC, the JV, et cetera, et cetera, that can grow earnings. And I mean if I look at the asset base for the NAV, I mean, if you just produce a very sustainable ROE, you can get to over-earning the dividend. The question is timing. So can you give us any color on how fast you expect various things to ramp up? I mean you did say for the outlook, you expect the remainder of 2019 to be active. The SBIC obviously isn't available yet. The JV isn't launched yet. So I presume that will all be on balance sheet. But can you give us any kind of ballpark estimates of how you think the timing of various initiatives are going to play out to the point of growing that -- those earnings to overcover the dividend?

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

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Yes. It's a great question. So first on the new origination side. As we've indicated with a subsequent event note, things are normalizing. We had to take a little pause in the last quarter as we were redoing the credit facility to deal with the greater than 1:1 leverage. So originations for this quarter are, kind of, back to, kind of, normal range. And we do have plenty of liquidity to deal with, kind of, the normalized origination flow. To the SBIC, we just got the green license -- the go forward, the greenlight a couple of weeks ago. We have an internal debate here at PennantPark, we think it's probably 3 to 6 months away from starting -- to start ramping SBIC III. So probably, kind of, mid-2020, we can -- if you'd want to try to model, kind of, mid-2020 is when we think we can start ramping that.

With regard to a joint venture, we're just going to be going out in the next couple of weeks. We have a formal process to assess different partners. Again, probably doesn't start ramping until kind of mid-2020. So between now and then, I think we're using internal capital that we've already raised through the credit facility, through the bonds. And then we start to see those 2 things kind of move into the limelight kind of mid- to late 2020.

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Robert James Dodd, Raymond James & Associates, Inc., Research Division - Research Analyst [4]

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Got it. I appreciate that color. On -- just sticking with that JV for a second. I mean when you're reviewing candidates, what's your -- most JVs out there, I think the partner is fairly passive. They're involved, but maybe passive in terms of originating element that go into the JV. Would that be reasonable to expect that? Are you trying to seek out a partner that can both provide capital, right, and -- but also bring originations to the table within that JV structure?

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

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Yes. So look, the JV we have right now with Kemper has been working fantastically. They're really terrific, and they add a lot of value in terms of advice and structure and a way to think out things. So they are a terrific value-added partner in PFLT. I think with regard to the new opportunity, I mean all options are on the table. We have fiduciary to look at all the different flavors. And if there's partners who can add origination into the mix, that's something we need to evaluate, and should evaluate, on behalf of our investors.

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Operator [6]

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We'll now take our next question from Ryan Lynch with KBW.

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [7]

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One thing I did want to focus on is your guys' equity portfolio. It's obviously fairly large today, about $193 million. If I look at the top five investments, they represent about $130 million of that $190 million. I'm very familiar with the Ram Energy and the ETX, both of those are energy investments and obviously have their own challenges in potentially exiting. But could you maybe talk about the other 3 in your top five, so MidOcean, PT Network and Wheel Pro? Can you maybe just give us a very high-level overview of what those businesses do? And what is the potential outlook for potentially exiting those investments? They've all been written-up pretty meaningfully. So just how are you guys thinking about those?

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

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Yes. No, it's a great question. Happy to run through it. Wheel Pro is the only one that came through equity co-invest. And they are in the automotive wheel business, aftermarket-driven and performing well. The company has grown substantially since we've invested in it. It's owned by a sponsor called Clearlake based in Los Angeles. Obviously, the company is doing well. And when you have an equity markup like that in a sponsor company, it's really -- it's a question of when and how much. Hopefully, this company continues to perform well. So that's kind of that -- snapshot on that transaction. The company's EBITDA is, I think, north of $130 million. When we got involved with it, it was $50 million, $60 million. So been be a nice ride.

PT Network and J&F are both equity that we got through restructurings. Both because of the markups you're seeing have been performing pretty well. J&F had some issues after the restructuring. It distributes gas pumps and products and services to gas stations. The company seems to have turned around. The results have gotten much better. They've done some add-on acquisitions that are accretive to earnings. We have, I think, about 1/3 of the company's equity. MidOcean is the -- is a sponsor and the control shareholder, owns the majority of the equity. And the company has been on a roll recently, so that's why you've seen a significant markup. There were some significant markdowns in its prior life but it seems to have found its footing in -- on the way up.

PT Network is a physical therapy company based in the mid-Atlantic. We recently took control from the sponsor. There was a bunch of missteps from the sponsor. We've put some additional capital in. Company's performance is better than expected. It's in an industry where there's some very attractive multiples. Companies have been sold for some very attractive sale prices and multiples of EBITDA. So you've seen a markup there as a result of both company's performance as well as where the comparable companies trade. Does that answer your question at this point, Ryan?

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Ryan Patrick Lynch, Keefe, Bruyette, & Woods, Inc., Research Division - MD [9]

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Yes. Yes. That's very good detail and helpful background on all those different businesses. I wanted to switch over to a question on the JV. Obviously, you guys are in the very early stages of that. But I'm just trying to think about, how do you guys think about, kind of, holistically look through leverage across your -- across the PNNT? Because obviously, putting the JV on debt structure with you guys will make an equity investment into that entity and then it has this off-balance sheet leverage. So to the extent that, that grows and becomes a meaningful portion of the portfolio, how do you think about that off-balance sheet leverage as a portion of the JV as a portion of your guys' leverage target?

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

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It's a great question. It's something we think about, and it really is driven by what are the underlying assets. At least at this point, we're envisioning it, and yes, it looks very similar to the JV we have in PFLT, where it's primarily first-lien, lower-risk, lower-yield senior secured assets that can be leveraged reasonably and safely at 1.5 to 2x debt to equity. So that's kind of how we think about it.

As you know, because we've actually done this and we're now in the market as a firm, middle-market CLOs, you can easily get 3 or 4x leverage, 3 or 4x debt to equity. So as we think about what's the blended overall asset mix of PNNT pro forma, at this point, any new assets, by and large, are going to be a lower-risk, lower-return, more leverageable first lien. And even with a joint venture, we think still reasonably leveraged and safely leveraged. We still have a second lien and mezz portfolio. As you mentioned, we have an equity -- co-invest in equity portfolio. We're monitoring those. We're not doing much in terms of the new second lien or mezz. That said, we've said to the team, if there's really compelling second lien or mezz out there, we want to see it. It's got to be super compelling right now given where we are in the cycle and the economy, but we still could do a little bit more than that. But I think by and large, the mission for this particular company at this point is work down the second lien and mezz, the equity co-invest and kind of ramp-up on the first lien side and put appropriate leverage against that, whether that's leveraged from our credit facility, leveraged from an SBIC or leveraged from a potential joint venture.

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Operator [11]

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Our next question comes from Rich Shane with JP Morgan.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [12]

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Two quick questions. First, obviously building the cash position at the end of the quarter, I'm assuming that, that has to do with the timing of the debt issuance. But I just want to make sure that there's not additional liquidity requirements that we should consider associated with any of the new facilities?

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

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No, that was just the bond that we did. You're right.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [14]

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Okay. Great. And then second question. Related to Hollander, second company we've seen this quarter in the bedding space that ran into some challenges. And the feedback we've had is it's -- a lot of it's related to sort of disruption in that industry, which leads to a really interesting question, which is, are there other industries that you're looking at this point where you fear that type of disruption that sort of leads to those outcomes where they're taking the portfolio, we should think about are there areas that you're avoiding based upon that?

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

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It's a great question. It's something we think about all the time in our investment community. That's one of the most treacherous things to think about investing for any investor in this environment is, if you're investing in a traditional business, is there disruption coming, and if so, when, right? So bedding is an area. Retail is certainly an area. And you could take the theme to any number of different industries, obviously the hotel industry and a number of different industries, the taxi industry, there's been disruptive forces.

Now we've spent a lot of time, for instance, talking about driverless cars. At one point, that looked like it was coming sooner, it may have become pushed back. What does that mean for the trucking industry, what does that mean for this industry, that industry? So it's something we, all of us, not only at PennantPark but all of us as investors need to be assessing. It was maybe a small part of why Hollander had issues but still a piece of the pie of why Hollander had issues. And it's something on every deal that we have in the traditional industry we need to be thinking about.

That said, on the other hand, we can take advantage of that. I mean, there's a company in our portfolio called Walker Edison, and it's one of the -- you see it, it's an equity co-invest markup. This company sells furniture on the Internet, right? So through Wayfair, through Amazon. Someone my age would never buy furniture on the Internet, but there's quite a few people today buying furniture on the Internet, and Walker Edison has been crushing it and has had significant EBITDA increases, and you're seeing their mark-to-market up because it's participating in that trend. So there's certainly a downside that you have to be aware of and potentially there's upside that you can participate in as well. So that's just one example of change.

There's another company in the portfolio we're seeing an equity markup called Dominion Services. They are in the voting machine business. They're in the voting machine business. So just think about that and what's going on with voting machines today and, kind of, the elections and all the issues around voting machines. This company has been a beneficiary because they make not only -- they make voting machines that do both paper and, kind of, the ATM machine-type voting machine. So there's both an ATM feature to the voting machines and there's a paper record. So this company has been a beneficiary of that change and you could see that in the equity markup in the portfolio. So it's a fascinating question, we could talk all day about. I'm happy to talk all day with you, Rick, offline, if you like. But there's pluses and minuses to all of this.

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Richard Barry Shane, JP Morgan Chase & Co, Research Division - Senior Equity Analyst [16]

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Well, 2 comments there. One, I hope you have better things to do than talk to me all day. And second, and I will make a bad dad pun here, it really does highlight how challenging things are when you think about the mattress business, and it is, here's my dad pun, a sleepy business and to run into that even in that sector, it just sort of underscores the challenges that are out there.

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

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Thank you.

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Operator [18]

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Our next question comes from Mickey Schleien with Ladenburg.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [19]

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I wanted to step back and ask a high-level question. So historically, PNNT was known as a BDC focused on the meat of the middle market, sort of, EBITDA of $25 million to $30 million, and obviously more second-lien mezzanine. As the balance sheet has changed and as your capital structure has changed, what sort of EBITDA levels are you targeting now, Art? And how is that affecting the sourcing of the deal flow that you're looking at?

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

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It's a good question, Mickey. We're still kind of focused on the $15 million to $50 million EBITDA range, so the mean median is still in the $25 million to $30 million zone. And we ask our folks to go find good deals, whether that be senior or second lien or mezz where the threshold and the bar is substantially higher now on second lien and mezz, but we're still open for business. And by the way, we think that's a really good place to be because it's below the threshold of the broadly syndicated market where the deals are mostly covenant-light, where the leverage is high and where there's very substantial EBITDA adjustments.

In our $15 million to $50 million zone, we're still getting covenants. The EBITDA adjustments are the adjustments that we buy off-on and that we diligence. We still have several months to do our due diligence. We don't have to rush to make a decision. Our average debt to EBITDA on senior debt is kind of in the mid-4s. So we think that's a good place to be. And also with the -- this move to these very, very large direct lenders, they've really moved to competing against the broadly syndicated loan space. And that's just fine because they're kind of leaving us alone in this kind of true middle-market space of $15 million to $50 million of EBITDA where we can still get covenants and where we can still do diligence, whatever adjustments there are.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [21]

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Okay. I understand. And to the extent you're building up the JVs, are they buying similar credits just to hire quality companies? Or are those companies somewhat larger, perhaps more club deals in there that reduces their risk and allows the higher leverage? How do you view that bucket versus the rest?

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

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Well, it's very similar risk/reward. And just to take a step back, I don't know if this was implied in your question, just because a company does $25 million of EBITDA versus one that does $70 million, certainly, there's pluses and minuses. We would rather do full due diligence, really understand what we're buying, get some covenant protection, really diligence the adjustments and lock down a very safe deal for our investors versus competing with a broadly syndicated market where decisions have to be made very quickly, where you don't have months to do due diligence, where you're competing with covenant-light, so if there's a covenant, it's going to be set very, very wide. The EBITDA adjustments are larger and less diligent. So all day long, we'd rather finance a well-diligenced, well-structured $25 million EBITDA loan than something that's covenant-light or covenant-wide with higher leverage, with less chance for diligence, in a bigger company. So that's kind of where our meat and potato is, that's where we're focused and that's what's populating our vehicles.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [23]

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I understand. One last question, Art. To the extent you're focused on first lien, there's no great definition or universal definition to first lien. What I'm getting at is to what extent is -- does first lien include unitranche deals, which are obviously very popular in today's market? And how actively do you sell the first-out pieces?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [24]

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Yes. So I'll take the second one first, which is, we don't sell the first-out piece, we like being at the top. The first part of your question is really the challenge you're making. I'm kind of smiling because as far as I can tell, everyone has a different definition of what unitranche is. We've been going on it recently, what's your definition of unitranche, what's your definition of unitranche, what's your -- and they have -- everyone's got their own definition of the loan-to-value, that's just capital beneath it or whatever it is. I think just to cut through what we are doing, our risk is generally first lien, top-of-the-capital structure, no one above us, and we're originating in the mid-4s today and generating about an 8% return. That's what we're doing. You can call that stretch change, you can call that classic first lien, you can call that whatever you want. The definition of unitranche is not clear and it swaps around. And what was defined as unitranche in 2010 is certainly different than what's defined as unitranche in 2019. So we're just going to tell everybody what we're doing, it's mid-4s debt to EBITDA, 8-ish percent yields, average EBITDA company $25 million to $30 million. That's what we're doing.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [25]

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And Art, just a follow-up. If a bank has extended a revolver ahead of you, which I know in some cases, you do yourself, but if it's a third party, do you still classify your investment as a first lien or not?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [26]

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A good question. It just depends on the size of that, and sometimes you get little ABLs. So if the ABLs are 0.5x or beneath, we'll still classify what's beneath that 0.5x as first lien. If the water gets murkier, which we don't do, unless if it's 1.5x or 2x, and then you're junior to that, we don't think you should be classifying that as first lien, that's junior debt.

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Mickey Max Schleien, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research & Supervisory Analyst [27]

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Yes. I agree, though, the issue is that even that's not consistent across the space. That's why I'm asking the question.

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Operator [28]

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Our next question comes from Casey Alexander with Compass Point.

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Casey Jay Alexander, Compass Point Research & Trading, LLC, Research Division - Senior VP & Research Analyst [29]

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A lot of my questions have been answered, but this is a little bit of an extension on the direction that Ryan was going, which is, you have a lot of equity in the portfolio, 15%, 16%, close to 20% of your portfolio is controlled positions. So you have a lot of positions where you have some say in it that are not income producing. So it would seem to me that being a little more aggressive at getting those things out of the portfolio and turning those into interest-generating positions would be paramount because those are 100% accretive to NII and your dividend coverage. So how do you think about being more aggressive? And in relation to the marks on those positions, probably investors don't care what your cost was on them originally, they're more interested in improved dividend coverage, which would make them feel more comfortable about investing in the vehicle.

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [30]

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I'm in. I agree with you, Casey. I'd love to get equity down and -- which can then be invested in income. So some of the things we -- some of the deals we don't control, like we don't control J&F, we don't control Wheel Pro, we do control some energy names. Now last I checked, there's been a dearth of M&A in energy. So there, we are trying to optimize those companies so that when M&A comes back in energy, we're in a position to exit well. But there's been really no M&A in energy. Once there starts to be M&A in energy, all ears. And if you have suggestions, Casey, or anyone who thought had suggestions, we are all ears. Right now, we'd love to deal with the energy names. But with regard to the other names where there's a good gain and we think it's fair value, we of course will look to monetize.

PT is a new one. We're kind of in the first 6 months of that. We still think there's some nice runway there. That sector has been attractive. The multiples are very attractive on exit. We still need to consolidate those operations and get it primed in the best way for an event, and that may take a year or 2. But that's right in our wheelhouse, and it's something that we can control ultimately. So happy to go through specific names if you want, if you want some more color on any of the specific names. I think I covered energy. I think I covered J&F and Wheel Pro. But if there are any other specific names, Casey, you want to ask about, I'm totally open to doing that.

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Operator [31]

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(Operator Instructions) We'll now move to David Miyazaki with Confluence Investment Management.

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David Brian Miyazaki, Confluence Investment Management LLC - SVP and Portfolio Manager [32]

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Just a couple of questions, kind of touching a little bit on what Mickey was asking about. As you start shifting your focus more to a senior secured sort of profile, whatever definition that may be, and you think about your energy, one of the conservations from outside looking in is that the energy problems came more from a commodity price as opposed to where you were in the capital structure. So if you think past your existing positions, do you think that energy in M&A and assume your secured position is something that will come back into the portfolio in the future?

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Arthur Howard Penn, PennantPark Investment Corporation - Founder, Chairman & CEO [33]

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It's a great question. You and I have had this debate before, and I think to quote you back to me, "you've paid the tuition, why not monetize that tuition by doing more energy ones, right?" That's -- that was the question at one point you asked me, David. And it's a good question. I think at least today, and we can have more -- I'm happy to talk to you whenever you like, we can have more discussion about it. For portfolios that today are owned mostly by retail shareholders, which is what BDCs are, I think we're going to avoid energy at this point in time just because we want to deliver stable cash flows. We want to stay away from commodity risk. And granted, there might be some eye-popping deals. I read an article Samsel is coming back in the energy space because he thinks it's reminiscent of real estate at the bottom. And maybe he's right, and we certainly hope he's right. But at least for the time being, certainly, while we have the energy exposure we have in PNNT, I think the idea for PNNT is to optimize what we have, position it as best we can for an exit if and when M&A comes back. We can control a lot of things with this company. We've been controlling as best we can the right-hand side of the balance sheet, which as you've seen the moves that we've made. On the left-hand side of the balance sheet, the moves up the capital structure to safer lower-risk securities. Unfortunately, we cannot control where the price of WTI is, West Texas Intermediate. So that's one thing we can't control. You might have seen we did mark down all 3 of our energy names last quarter. They've been marked down appropriately so. Despite that, we still had NAV growth on the underlying assets. So it's just kind of -- we've just got to play it through, optimize the hand we have with those names. And Casey's right, and you're right, over time, we've got to, kind of, get this equity percentage down, but it's a question of how and how do we best optimize the outcome for investors.

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David Brian Miyazaki, Confluence Investment Management LLC - SVP and Portfolio Manager [34]

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Right. And I'm agreeing with all that -- that overall thesis that it does seem to bring some real volatility into the credit risk in the portfolio, that can be disturbing to people who are looking for consistent income or predictable income. But moving along a little bit to your comment that you're open to suggestions, one of the things that -- I know coming up with a fair value for an investment is an art as much as a science. And whether or not you could actually sell the position at that market is always an open question as well. But it seems to me that if you could sell your equity or your workout positions at anything that was higher than 70% of your mark and then use the proceeds to buy back stock, then mathematically, you wind up doing something that's accretive, and you get something off of the balance sheet that isn't income producing. What are your thoughts on that concept?

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

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It's an excellent point, and that's what we try to do. We're always assessing exit prices, the pluses and the minuses, how -- what that means to our capital structure, debt and equity, and it's something we continue to do with our Board. And we're just starting to get some ups in some of our equity portfolio. We talked about J&F. We talked about PT Network, which is a relatively new position. So we're just starting to see this kind of green shoots concept in some of these equity names. So it's always a question of, I'll keep using the analogy, how high do you let that grass grow before you harvest it, right?

So again, it's a hard -- I wish there were a black box or an algorithm I can put it into, which would say, here's magically when you should sell these assets, here's magically what the capital structure should be, debt and equity. Some of these green shoots are starting to kind of come out of the ground. And if we think they can really grow, and some of them I think -- we think so, the right thing for any of you might be to let them grow a little bit, but that's something we constantly are assessing and talking about.

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David Brian Miyazaki, Confluence Investment Management LLC - SVP and Portfolio Manager [36]

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Yes. And I do think that that's kind of what your job is to figure out when do you -- to move on and maybe not get all of the grass growth. But at the same time, there is a drag and when you have -- I think it kind of worked out in the past that are still in your portfolio, it kind of weighs down the outlook in the future. I wanted to move on to, kind of, the last concept here that whenever you talk to a BDC manager and ask them where in the middle mark is -- when the middle market is the best price to be lending, the answer always is, wherever there is a bid happen to be lending. So if you look at the big guys, they talk about being able to write a check and a big check, $100 million, $200 million-plus, certainly at closing, bigger companies, better balance sheets, better credit risk. And then at the other end of the spectrum, the small guys are looking at companies where the pricing is more stable, the terms are more stable. And so when I think about it where you guys are, in the, sort of, the $15 million to $50 million EBITDA land, to some extent, you are constrained because your stock has not been above net asset value for so long. So now with the change in leverage, you are able to increase the size of your portfolio. But if you really have the ability to grow the company bigger with a larger equity base, do you think that being in the $15 million to $50 million is the optimal EBITDA target? Or would you think that over time, as you move past the problem loans and theoretically get back above net asset value, would you want to be doing more in the $50 million to $100 million neighborhood?

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

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Good question. So number one, you're absolutely right. Everyone talks their book. Of course, everyone talks their book. In terms of the statistics, I mean S&P and LCD have statistics on defaults and recoveries of broadly syndicated loans to bigger companies versus middle-market loans. It's out there, it's accessible. It is clear that over time, middle-market loans provide fewer defaults and higher recoveries in the broadly syndicated loans, which are now being done, in some cases, by the larger direct lenders.

So those numbers are out there, we can send them to you if you like. They are over many years. They are over a cycle, they're over a recession and financial crisis. It's not PennantPark versus some other firm, that's a data that's verifiable with defaults and recoveries of broadly syndicated versus middle market. And you now see many of our bigger brethren taking share out of the broadly syndicated. So you can ask them that question, that's verifiable data in terms of defaults and recoveries.

In terms of our constraints in our business, and you may have seen, we are growing the non-BDC side of our business, we have several private vehicles, managed accounts that do and participate in many of the deals that are being done by our BDCs under our SEC exemptive relief. So we're allocating capital across our platform to the BDCs as well as the private vehicles under that exemptive relief, and that has helped us grow bite size. Because when you think about it, if our average company is $25 million of EBITDA and it's leveraged 4.5x, you're talking like what as $110 million, $120 million ticket if we wanted to do the whole thing, if we could do the whole thing. And that's kind of what we're aiming for because our borrower clients, our sponsor clients, are saying to us, hey, PennantPark, we'd like you to be bigger, we'd like you to be a bigger piece of this deal, we'd like you to do the whole deal. So we're getting there. We've made substantial progress with our private vehicles, with our managed accounts. And now with the BDCs, with their ability to grow through incremental leverage, we're getting there, and we're on the precipice, and we're taking more and more share of those deals because those sponsored borrower clients want us to be taking bigger bites. We have no current intention of competing with the broadly syndicated market with companies with EBITDA of $50 million, $60 million, $70 million as we've said. You're competing with a market that is at a very aggressive level in terms of leverage, either no covenants or very muted covenants and very high EBITDA adjustments.

So for those people who want to do that, gobble us. And if they want to be taking share because the company would have been ready to be BBB minus or a CCC, they can have that share all day long if they want. They've got lots of capital to deploy, they can deploy it quickly. They can talk their books about the size of the companies. But it's a bubbly time to be competing against that market.

Again, we like where we are, where we can control the diligence, we can control the covenants, we can control which EBITDA adjustments we take or we don't take. We've had an excellent track record over many, many years. We've -- we shared with you, it's about a 9 basis point annualized loss on our senior business over many years. Take that all day long. It's a nice place to be. We've had a very good track record, and we're happy to populate our vehicles with that.

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David Brian Miyazaki, Confluence Investment Management LLC - SVP and Portfolio Manager [38]

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Right. I thank you for that insight. So the last thing I wanted to touch on is the EBITDA add back and the erosion of the covenants, seemingly started to really pop up in greater frequency, call it, 18 or 24 months ago in that range somewhere. So when you think about which is the bigger hazard, I'm not really sure which one it is. Is it the EBITDA add back or the lack of covenants or weak covenants? But having now had several quarters of when these concepts were first brought in, if you look at the overall market, particularly upper middle market, and you think about the EBITDA add backs that were put in place a couple of years ago, when you look at the credits today and not the ones that you've done but the ones that you've just seen and didn't participate in, how bad are the EBITDA misses versus the actual EBITDA that's happening today versus what was projected versus the add backs a couple of years ago? And do you have any sense for how bad those add backs have been?

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

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Great question. We don't have any data on that. And I can go through each -- I can go through each of our nonaccruals with you at any point and tell you what the mistakes that were made. I just can't tell you about the EBITDA adjustments and then whether they've been realized. Look, we've had a reasonably good economy. We've had a reasonably good economy and that's covered for a lot of the issues. And as the saying goes, when the tide goes out, we see who's swimming naked. So the tide has not gone out. So things seem to work, which is why you see record high leverage multiples, record high adjustments and by the way, record high enterprise value multiples that the sponsors are paying. So there's this whole big logic of, well, the company is worth 15x, so it can easily be worth 7x, and I've got great loan-to-value, and that may work. These may be fantastic companies that will continue to do well, and that may be just fine. And that 7x is, by the way, an adjusted 7x. So there's a whole logic that people are buying off on. We'll see. When the tide goes out, we will see what happens.

Based on our experience from the financial crisis and the recession last time around when you did see very high leverage numbers, a lot of them -- a lot of it worked but some of it didn't work. And when it didn't work, it was very, very hard harsh. The severity level was very harsh because the sponsor -- when a sponsor's paying 15x and you're leveraging 7x, if there's a little bump, the sponsor is more likely to fix it. But if there's a big, big bump, they're still out of the money, the lender is left holding the bag. So our experience, just looking back from a decade ago, is a lot of those companies did just fine, but when there was a bump, it was a very severe outcome for the lenders.

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David Brian Miyazaki, Confluence Investment Management LLC - SVP and Portfolio Manager [40]

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Okay. So basically, you're saying that if the underwriting is poor because of the EBITDA add back or because of the lack of covenants, we haven't really seen the consequences because the economy in general had been pretty good.

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

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Yes.

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Operator [42]

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It appears there are no further telephone questions at this time. I'd like to turn the conference back over to Mr. Penn for any additional or closing remarks.

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

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We are certainly grateful here as we head into Thanksgiving for the relationships we have with our investors and our research channels. Thank you for another year. And as we head into Thanksgiving holidays, we wish everybody a great Thanksgiving and happy holidays. And next time we'll be talking to you will be in early February. Thank you very much.

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Operator [44]

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And once again, that does conclude today's conference. We thank you all for your participation. You may now disconnect.