We reviewed and commented on PennantPark’s (PNNT) earnings report a few days ago (see our prior article/blog). Since then we’ve burrowed deeper by reviewing both the 10-Q for the quarter ended December 31 2009 and listened to the conference call. We’re still positive on PNNT’s short term prospects after that homework. In fact, we bought more PNNT last week. Nonetheless, there are a number of serious issues with this company that need airing, and that both current and prospective shareholders should take into account:
Management Fees: There was nothing new about the level of fees in the 10-Q but it bears mentioning that the company is charged full freight by its Investment Adviser. First there is the Base Management Fee: 2% of gross assets. Then there’s the Incentive Fee, which essentially amounts to 20% of the company’s Net Investment Income as long as PNNT meets a pre-determined hurdle rate. PNNT’s earnings have been above the hurdle, so it’s been receiving the Incentive through the recession. Anyway, these two fees amounted to $2.5mn and $1.8mn respectively for a total of $4.3mn.
When you throw in PNNT’s Administrative expenses and other G&A expenses, total Operating Costs aggregate $5.4mn, or 40% of Investment Income. Or put another way, Operating Costs annualize at 4.2% of Investment Assets At Cost. PNNT may not have the highest costs of all the BDCs (we have not yet done the calculations) but has to be one of the most expensive. In fact, when excise taxes and interest cost is added to the expense mix only 53% of Investment Income from all sources gets down to the Net Investment Income line. If we ignore the non-cash PIK income booked for the quarter, the number is only 44%.
Little Disclosure on Bad Debts: Management does not provide much public information about troubled loans and non-accruals. This is unusual for a BDC. Clearly some of the analysts following the company are aware of the positive and negative developments affecting some of the portfolio companies because they are regularly traded (Realogy for example). There was much back and forth on the conference call. However, for the rest of us, we’re left in the dark. There is no information about loans on non-accrual in the 10-Q itself. We scanned the investment assets holdings list for clues but did not find anything clear cut. It seems that PNNT sells off any loans that go on non-accrual, but there is no discussion in the 10-Q, not even to say that there are no loans on non-accrual.
As for Realized Losses, disclosure is very minimal, which is distressing because PNNT has written off a material amount of its assets. Just this last quarter the company incurred Realized Losses of ($17mn), which amounts to more than two quarters of Net Investment Income. In its short 3 year history PNNT has booked Realized Losses of ($67mn) or 20% of its paid-in capital. We’d appreciate more explanation from management about which loans resulted in losses and why and what’s the company’s future approach (sell off losers ? hold on until the market changes ?).
Unusual Accounting Treatment: PNNT was one of the few BDCs who opted to mark their debt to fair value rather than cost. This may have helped the company avoid defaulting under the 200% asset/debt coverage limit during the worst of the asset value implosion last year. Now the company is lumbered by earnings which swing with the perceived value of the debt (which is still not back to par despite the fact that PNNT is borrowing normally and has raised new equity in September 2009 and is valuing its own loan assets pretty close to cost).
Another result is that by reducing the value of its debt liability PNNT’s NAV is artificially higher than what most observers using the traditional accounting methodologies . That adds $ 1.70 to PNNT’s NAV, which suggests the company’s “real” NAV is $10.16 rather than the $11.86 reported. For those who like to see the glass half full that suggests that PNNT, with a stock price at $9.02 on Friday February 5th 2010, is trading at 89% of its “real” NAV rather than at 76%. Our main beef with all this is losing the comparability with other BDCs and having to do this extra calculating.
Borrowing Capacity: Like many (but not all) BDCs, PNNT is very close mouthed about the status of its borrowing capacity under its debt agreements. In this case, PNNT has a $300mn Revolver at very favorable rates and which does not expire until 2012. In the Conference Call management seemed to suggest that the company was going to continue to increase borrowings under the Revolver, which was already occuring last quarter. On paper, PNNT has $55mn in undrawn capacity.
What we don’t know is how much real availability PNNT has and how close to its covenants the company is navigating. Just for fun we reviewed the 2007 Loan Agreement in PNNT’s SEC filings section. We learned that the advance rates on assets that the lenders provided were very generous from a borrower’s viewpoint, which suggests that PNNT won’t have borrowing base hiccups like some BDCs (re GSC Investments-GNV).
However, the company is required to keep at least 200% asset coverage of debt outstanding. Here the previously mentioned unusual accounting benefits PNNT because the debt is carried at below par value. If the debt was carried (or is carried-we don’t know) at par, asset coverage is pretty close to the required minimum.What happens in the quarters ahead if the company’s borrowings are marked back to par ?
For an investor, without any information or guidance from management, it’s very hard to determine how close to the covenants PNNT is operating. Is there plenty of availability which could result in greater loan volumes, higher earnings and higher dividends or has PNNT reached its maximum allowable capacity ? What will happen if we get even a mild retrenchment in asset values ? Is there some other covenant (there are so many different triggers in these loan agreements) which could trip the company up ?
We’ll conclude by summing up the dilemma that an investment in PennantPark creates: The company is a Dividend Superstar (that’s our patented term for any high dividend paying company which was able to maintain or even increase its dividend through the 2008-2009 Great Recession), with a clean and diversified portfolio (albeit from selling off its losers); an inexpensive and flexible debt financing source and good prospects to increase earnings further in 2010.
As of Friday the company trades at only 8X the latest Net Investment Income annualized, and the current yield is 11.5%, in the middle of the BDC pack. Management is conservative in distributing less than it is earning, which always get a gold star from us. At the same time, shareholders are paying a high price in fees and costs for this steady income.
More importantly, unusual accounting methods and minimalist disclosures make evaluating just how much risk an investor is taking on by owning PNNT a very difficult proposition. We manage the risk by a) keeping our eyes peeled, b) by under-weighting relative to most other BDCs the aggregate investment we make in PNNT.
Disclosure: Author holds a long position in PNNT