|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||169||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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Margin of safety is heightened not only when a portfolio of assets is marked down to prices reflecting short term market turmoil, but also is enhanced when a further significant discount is provided by a stock selling well under the reduced market value of the portfolio. PennantPark Investment Corp (PNNT) provides such an opportunity with the added bonus of a visible path to near 50% total returns.
PNNT is a small BDC that completed its IPO on April 24, 2007. Chairman and CEO Arthur Penn formerly was President and COO of Apollo’s BDC, Apollo Investment Corp (AINV). BDC management is critical, and it is clear with this background, and AINV’s relative success among the BDC’s that IPO’d in 2004, that Mr. Penn ‘gets it’ about how these vehicles must be operated for shareholder benefit. Further background is available on the prior VIC writeup of August 2007 by raf698.
The investment thesis for PNNT is that the price is sufficiently depressed for a margin of safety, that management’s plan for increasing the yield from the portfolio by moving toward a greater share of ‘core assets’ within the portfolio (subordinated debt, second lien secured debt and equity investments) is viable and already in evidence, that management understands and resists the idea of raising expensive equity capital at sub NAV prices, that even absent fresh equity there is sufficient liquidity to accomplish the migration to higher yield core assets, and that this discipline in exercising the business plan will lead to increased net investment income and a growing dividend which is the ultimate driver of a BDC’s stock price.
Margin of Safety
At 3/31/08, PNNT’s portfolio (at cost) consisted of 39.9% bank debt and senior loans, 30.7% 2nd lien debt, 26.9% subordinated debt, 0.2% preferred equity, and 2.2% common equity. At fair value, the ratios of debt investments are all within 0.7% of the investment mix on a cost basis, indicating writedowns are across the board. The entire portfolio cost is $413.6MM and the 3/31/08 fair value is $335.9MM, representing a markdown to a discount to cost of 18.8%. Because PNNT is on a fiscal year ending 9/30, it has not yet formally adopted FASB 157. It does use quoted market prices where possible in its valuations. In the most recent conference call on May 9, Aviv Efrat, CFO, reported that “we expect to have no economic changes when adopting FASB 157”. In short, effectively PNNT is already operating on a FASB 157 basis.
NAV on this aggressively marked down basis is 216.3MM or $10.26/share. With a share price of $8.01 (market cap 168.8MM), this is a further discount to NAV of 21.9%. The net assets at cost (294.1MM) are thus discounted 42.6% by the stock. Given that senior debt pricing has strengthened a little since 3/31, the stock is even more discounted to current fair value than the 3/31 statistics indicate.
BDCs will experience defaults as we move through a weak economic environment ahead. PNNT is no exception. There are no nonperforming assets at present, but the current combined discounts certainly allow for whatever real credit risk will be realized in the long run. Consider the effect of a 15% default rate with 50% recovery. [This assumption was developed by FBR Capital Markets analysts in a bearish BDC report released April 16.] Keep in mind a BDC may run a maximum of 1:1 D:E leverage. Thus the loss to equity would be .15 x .50 x 2 = 15%. PNNT’s equity has declined by 20% in the last 6 months due to mark to market writedowns. Thus the marks to date already more than cover potential actual loss effects. The further discount by the stock price just deepens the margin of safety.
More ‘Core Assets’ = Higher Yield
Like many newer BDC’s PNNT came to market with a portfolio already in hand. In PNNT’s case, this was a $237MM portfolio of bank debt and senior loans. Hindsight is 20/20 and in retrospect, staying in cash would have been much better. There will be losses realized from that initial decision. But the issue for a new investment is how PNNT now manages the hand it dealt.
The business plan contemplated gradually replacing these securities with so called ‘core assets’ of subordinated debt, second lien secured debt and equity investments. PNNT’s management has indicated it is very picky about participating in equity positions in this environment, so most of the rotation will be going into these junior debt securities. The excesses of higher leverage, low interest rates, and weaker covenants have largely been wrung out of new originations today, and arguably those investments initiated now should perform well as a class. Yields are certainly more appropriate for the risk, and for PNNT particularly this rotation from the senior debt to core assets can drive net investment income growth absent any overall increase in assets on the balance sheet. PNNT’s first lien debt yielded an average of 5.3% at 3/31/08. At the same time its subordinated and second lien debt yielded 11.7%. Even more critically, its newer originations in the last 3 months were higher than this average with 31.5MM in two new companies with debt yields of 14.4%. (In the previous quarter debt originations averaged 12.9%.) At 3/31/08 there is up to 134MM of senior loans at fair value that can be recycled. The balancing act is whether they can price back to mid 90s before PNNT desires cashing them out.
In addition, assets can grow through leveraging closer to the BDC limit of 1:1. PNNT has a $300MM capacity revolver that runs to June 2012 with a price of LIBOR + 100. At 3/31/07 this was set at 5.4% with an outstanding balance of $194.5MM. Cash is at $81.3MM, so net debt is just $113.2MM with an implied availability of $186.8MM. The remaining effective availability however is about $93MM, due to the leverage restrictions under BDC regulations tied to the reduced net asset value.
Using very cautious assumptions that do not assume higher prices than 85 on loans sold, and interest rates on new originations of 13%, you can show PNNT generating a 26 cent per share quarterly net investment income run rate by 3/31/09. This modeling accounts for the full management fee expense as the initial waiver of the full fee expired last quarter. It incorporates a full 20% incentive fee on investment income, and holds ‘fixed’ costs fairly steady at around $1.2MM. It isn’t difficult to see a 2 to 3 cent dividend increase possible by the end of this time period.
Margin of Safety II: Cash Flow
In the asset value discussion, the bear case view of up to 15% delinquencies of speculative grade loans in a recessionary environment was broached. One must examine this impact on the net investment income. The 15% speculative grade debt number overstates the impact on senior credits and a portfolio with other elements. Plus PNNT will be originating over 40% of the portfolio after pricing and deal terms improved. There is also some real world reporting to compare: American Capital Strategies (ACAS) is the only BDC with a long history of reporting portfolio pool statistics. In 2002 and 2003, when broader default indices previously peaked, ACAS hit NPA peaks of 7.4% and 7.9% versus the cost of its entire portfolio. The model for PNNT runs a 10% revenue reduction which is a more aggressive level than actual experience of a BDC reporting such numbers. In applying this 10% revenue reduction from the base case a year from now, the model appropriately adjusts the performance fee downward. Additionally, the asset value is marked down about 5% to account for credit specific marks in such a circumstance, thus reducing the asset management fee. On this basis, the model returns a 22 cent NII, indicating PNNT’s ability to sustain the current dividend in a high default environment.
Resisting Expensive Equity Capital
Mr. Penn made a very refreshing statement in the recent conference call: “We don't believe it's a God-given right for every BDC to always grow, grow, grow. It's a legitimate strategy, we think, if you're fully invested to clip a coupon for a while.” I don’t expect a rights offering here that would be marginally accretive to shareholders and ramp up fees for management. Clearly Mr. Penn understands the long term benefit of not abusing existing shareholders and waiting for his stock to price to NAV (or better) before raising more equity capital. By increasing net investment income per share as described above (and the dividend), the share price will gradually return to a more appropriate level to expand the capital base with cheaper equity capital than is available now.
PNNT has originated at an average $50MM pace per quarter since September. This implies the need for $200MM of capital to fund this origination pace over the coming twelve months. All told, there is easily 227MM in capital for new originations from 93MM of usable revolver capacity and 134MM of senior loans at current fair value. PNNT would not likely sell these at prices in the 80’s but it was stated in the conference call on May 9th, a “big chunk” of the portfolio was again trading in the 90s. With nearly two quarters run rate of revolver capital, there can be patience in selling senior debt into the current pricing picture. Origination will be lumpy, and selling decisions will be value based just as the investment decisions are based.
Return on a Current Investment
PNNT closed June 17th at $8.01 per share. The current quarterly dividend is $.22/share (11.0% annualized yield) and I believe the next 12 months should provide a total $.90 dividend. If one expects the portfolio to return to at least 85% pricing then that would put NAV at $11.00. Price convergence to that level produces a $2.99 gain on a current investment. Dividend growth gives that premise a favorable chance to be realized. Total 12 month return then is $3.89, or 48.6%.
If you don’t accept the premise of the stock price trading to NAV, then 0.9x forward NAV would be $9.90 or a gain of $1.89. Simply maintaining the $.88 annual dividend rate provides for a total return of $2.77 or 34.6%.
I think either of these is an excellent risk adjusted return given the huge discounts to current NAV and portfolio cost the current share price provides.
Upsides: increasing floating interest rates boosts NII as higher revenue more than offsets higher revolver costs and greater performance fee charges. The implied gain in NAV from a stabilizing and rising leveraged loan index allows more use of the revolver capacity than described, which allows for either greater origination and/or greater retention of senior debt.
Downsides: higher defaults lead to a plateau of NII as discussed above. Lower origination/rotation to ‘core assets’ reduces NII growth, but does not eliminate it.
The primary risk is credit risk, but as discussed above, the portfolio marks and further share price discount more than account for that risk. Secondarily, further writedowns are possible, but the leveraged loan market appears to have bottomed, so aside from credit specific problems, I think we’ve seen the bulk of the valuation decreases.
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