Torsten Asmus
I took a conservative stance on PennantPark Funding Company (NYSE: PNNT) since early January of this 12 months once I revealed my first article on this BDC. The principle causes for my skepticism about PNNT have been as follows:
- Extreme publicity to non-first lien investments, making the BDC riskier than the common peer within the area.
- A skinny margin of security in terms of fundamental dividend protection.
- Excessive focus in fairness devices, making dividend protection much less predictable as distributions from fairness investments are inherently extra unstable than from, say, collateralized investments.
A couple of months after publishing that first article on PNNT, I revised the thesis by summarizing the Q1 2024 earnings report. It was clear from the info that there aren’t any grounds for altering the thesis. Throughout the first quarter, PNNT recorded noticeable unfold compression, important improve in exterior leverage, and moreover, there was no signal of elevated dividend protection (regardless of the rise in leverage).
But when we have a look at the efficiency now, it is clear that my thesis, particularly after digesting the Q1 report, was improper. PNNT managed to considerably outperform the BDC market.
YCharts
Let’s try the newest earnings report and see if there are legitimate causes to be extra bullish on PNNT’s earnings and dividend prospects.
Evaluate of thesis
Q2 2024 earnings report incorporates blended messages. On the one hand, there’s some deterioration of fundamental basic indicators. Then again, PNNT’s aggressive place has improved. The advance in PNNT’s place, mixed with a ~10% dividend improve, precipitated such a market response that the share worth considerably outperformed the BDC index.
PNNT reported core web funding revenue of $0.22 per share throughout 2Q20, which is $0.04 down from 2Q2023 and $0.02 down from the earlier quarter. In different phrases, momentum in underlying money era is poor. As well as, the current dividend improve now implies that the quarterly fundamental dividend cost has reached $0.24 per share, which is larger than the results of the underlying web funding revenue this quarter.
Thus far it would not look sustainable in any respect.
A caveat as to why administration has determined to extend dividend distributions whilst underlying web funding revenue declines is in relation to return on fairness. Specifically, PNNT holds roughly 17% of its portfolio in fairness and most well-liked devices, and a further 6% in a separate JV, which can be largely pushed by capital dynamics. Which means along with producing money from interest-bearing investments, PNNT acknowledges revenue from profitable exits or revaluations on a reasonably systematic foundation. These elements allow PNNT to shut the hole between dividends and web revenue from underlying investments. For instance, the rise in web property (earlier than the distribution of dividends) this quarter was $0.25 per share, which implies that the dividend is roofed.
One other facet that pertains to bettering PNNT’s aggressive place comes from the truth that many of the investments that PNNT makes are positioned within the core mid-market section, the place competitors shouldn’t be as fierce as within the higher mid-market area. As a result of competitors within the core center market shouldn’t be as robust as elsewhere within the BDC section (since firms with EBITDA of $10 million to $15 million are under the edge of the syndicated and high-yield markets), PNNT can keep away from extreme strain on spreads and tight requirements underwriting.
Throughout a current earnings name, Artwork Penn – chairman and CEO – offered some good shade on this subject:
On common, we’ve seen first lien spreads tighten by 50 foundation factors over the previous six months. Nonetheless, we proceed to imagine that the present crop of center market prime loans is superb. The core mid-market has decrease leverage, larger spreads and upfront OID, and tighter covenants than the upper-mid market. Regardless of the erosion of covenants within the higher mid-market and core mid-market, we nonetheless obtain important covenant safety.
Whereas the 50 foundation level tightening creates challenges for underlying web funding revenue (as we see in Q2 numbers), it’s nonetheless considerably decrease than what different BDCs have skilled.
With regards to strict adherence to covenants, the quarterly web funding financing statistics verify that PNNT has been capable of comply with a conservative coverage. The weighted common debt-to-EBITDA ratio of the brand new financing was 4.3x, which was 0.01x under the overall portfolio weighted common of 4.4x. Equally, curiosity protection statistics remained at a secure stage.
On this context, Artwork Penn additionally made an attention-grabbing remark, declaring that there’s a statistical profit to conserving allocations largely in the midst of the market:
A lot of our friends are targeted on the higher mid-market, saying these bigger firms are much less dangerous. This can be a notion which will make some intuitive sense, however the actuality is totally different. In accordance with S&P, loans to firms with EBITDA of lower than $50 million have decrease default charges or larger reimbursement charges than loans to firms with larger EBITDA.
Lastly, earlier than we get to the abstract part, I might like to spotlight Artwork Penn’s response to an analyst’s query about total dividend sustainability given the suboptimal dynamics of core web funding revenue:
First, it is essential for everybody to know that we’ve loads of overflow, in all probability round $1 per share of overflow, that we’re nonetheless going to want to repay a good portion of that. And now you flip to what’s our recurring NII. And we imagine that primarily based on the efficiency of the portfolio primarily based on the continued development of the three way partnership, that $0.24 is achievable on a recurring foundation anyway.
Backside line
General, Q2 2024 earnings yielded some fairly blended knowledge, the place we might see a divergence between the basics and administration’s optimism about PNNT’s means to ship even larger dividends.
Optimism is essentially justified given PNNT’s deal with the core center market, which displays softer competitors, permitting BDCs to keep away from spreading compression or decreasing portfolio high quality simply to get new volumes. Moreover, there’s important worth potential embedded in PNNT’s fairness and most well-liked inventory positions, which, as soon as realized, might assist dividends.
Having stated that, I nonetheless do not feel snug with extended PNNT for the next causes:
- Exterior leverage at 1.4x remains to be very excessive and nicely above the sector common.
- PNNT’s means to pay dividends is determined by how profitable the share sale element is, which is inherently an unpredictable course of that is determined by market situations.
- The truth that the online funding revenue backside line continues to say no, whereas leverage is so excessive, will increase the danger that PNNT will change into much more depending on an unpredictable fairness sale (and JV monetization) course of.
On account of this dynamic, I nonetheless are likely to keep away from PennantPark Funding Company.