|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||78||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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Pennant Park has been written up twice before on VIC (8/8/07 at $13.33 and 6/18/08 at $8). Hopefully we will be third time lucky.
Given the prior write-ups, I won’t go into much detail, other than to say that PNNT has a portfolio of loans originated over the past 20 months, including senior, second lien senior, high yield and mezzanine loans to buyouts. PNNT has a well-regarded and experienced management, led by Art Penn. The original business plan was to follow in the footsteps of Apollo Investment Corp (AINV), a BDC founded by Apollo Management. Art was COO of AINV from inception in 2004 until late 2006, when he left to form Pennant Park.
BDC’s are pass-through vehicles which have to pay out substantially all their earnings as dividends, and cannot have debt greater than 50% of total assets. Apollo, the sponsor of AINV, did very well because AINV traded above its NAV until this year and they took advantage of that by doing three subsequent equity offerings, greatly increasing total assets and therefore their fees (like the hedge fund business, but actually better, as explained below). The fee structure is also attractive for the sponsors, as they receive a fee of 2% of total assets, plus incentive fees of 20% of investment income from interest, plus 20% of realized and unrealized profits (or losses), without an offset of the two parts of the incentive fees against each other. Also, there are no redemptions. The business is potentially a great creator of wealth for management and sponsors, and, in retrospect, a not-so-mart money leveraged yield vehicle for investors.
At this point, I am not looking at this like a business or as a yield play - perhaps the mistake made in prior write-ups - but purely as an opportunity to acquire a portfolio of leveraged loans at a significant discount to today’s NAV. The investment thesis is that the credit markets are beginning to slowly improve since hitting bottom in late November, with the various indices and ETF’s that track the lower-rated corporate debt up 3-15% since then – and PNNT is an attractive way to bet on a continuing recovery. If you are not interested in making a bet on the recovery of the leveraged loan and high yield markets, this is not for you.
One other point before I lay out the financial analysis. The company’s fiscal year ended 9/30/08, and they elected to adopt SFAS 159 as of October 1, 2008, which will allow PNNT to carry its debt at fair market value, rather than face value. This helps with covenants and with the BDC debt limitation. The company disclosed in the 10K that the debt would have been discounted on October 1 by roughly 20%, giving an immediate boost to equity and NAV. As a value investor in the equity, we can certainly question the idea of a company carrying debt at a discount when the entire face amount is ahead of us in the capital structure. The flip side of the argument is that it enables the company to better match its assets, which already get marked to market quarterly, against the liabilities. For our analysis, we will look at it both ways – on the face amount of the debt, and on the estimated carrying value
|S&P Leveraged Loan 100||1,187||935||-21.2%|
|HYG - High Yield ETF||82||76||-7.3%|
|Equity - Pure Guess||-50.0%|
|Second Lien (excl. Swift)||95||88|
|Sub Debt (excl. Realogy)||156||145|
|Realogy and Swift Bonds||19||8|
|Estimated 12/31/08 Balance Sheet|
|Total Debt - At Market (assumes 30% discount)||112||112|
|Total Debt - Face Amount||160||160|
|Equity Value - Debt at Market||202||188|
|Equity Value - Debt at Face||154||140|
|Equity Value per Share - Debt at Market||9.63||8.95|
|Equity Value per Share - Debt at Face||7.34||6.67|
So, an investment in PNNT at $3.50 per share is a purchase of a leveraged pool of assets with an NAV of $6.67-7.24 (using debt at face). If the debt markets continue to recover, it would not be crazy to see NAV get back to $10-12 per share, and the discount narrow to somewhere between 0 and 20%, for a target upside price of $8-12.
There are a few other points worth mentioning. First, the company is leveraged, and has an attractive credit facility at Libor + 100 maturing in June 2012. If the company defaults, it could be catastrophic for the equity holders if the lenders accelerate and the company is forced to sell off relatively illiquid investments at even more distressed price. The main covenant is the Asset Coverage Ratio, which requires the company to maintain total assets to total debt of at least 2.0x. SFAS 159 helps out here, and we estimate the covenant to be in the 2.7-2.8x range at 12/31/08, giving them meaningful cushion. PNNT is likely to be closer on the borrowing base formula, but this is partly under the control of the company and we believe they still have excess availability.
The second point is that this is an expensive structure. The fact that the management company can continue to earn incentive fees on the investment income from interest, without it being offset by realized and unrealized investment losses on principal, is not only distasteful, but means that the total operating expenses are in the range of $15 million annually. Therefore, if you compare this to buying an ETF or closed end fund as a way to play the debt markets, the expense of doing it through PNNT is high.
Finally, the annual dividend of $0.96 is at risk of being cut by defaults on the portfolio, especially by Realogy or Swift. Even though the two investments will be marked down at yearend to a total of around $8 million, versus combined cost of $53 million, neither has defaulted yet, and they are contributing $6 million of interest income. If either or both default, investment income could be cut by almost $5 million (net of the incentive fee), which would reduce net operating income by up to $0.25. Other defaults would also eat into net operating income and cause a reduction in dividends. Our reasonable downside for the dividend is $0.50 per share.
On the positive side, we have a high regard for the management team. They have been buyers of stock throughout this year, including since mid-November, and we believe they are motivated to maximize shareholder value over time. This is a talented and experienced team, and we would not be surprised to see them engaged in some interesting corporate actions, such as merging with other BDC’s to become a consolidator, converting into or merging with a bank, or other actions that acknowledge a need to change the business model. The important point is that unlike a number of other BDC’s, we believe that PNNT is adequately capitalized and has a decent enough portfolio to get through these times, assuming the debt markets do not get materially worse.
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