- This article uses my "optimal leverage" analysis to assess dividend coverage for PennantPark Floating Rate Capital.
- The BDC industry is experiencing yield compression and 7 out of the 26 BDCs that I cover have recently cut dividends.
- I will use this series to project which BDCs are more likely to increase or cut dividends in the future.
Over the next two weeks I will be assessing dividend coverage for most of the 26 BDCs that I cover in an effort to uncover companies that have the potential to sustain or increase current dividends. I will also be using this information to update my latest "BDC Rankings: May 2014". For more details regarding this series and for the dividend coverage results for Gladstone Capital (NASDAQ:GLAD), Golub Capital BDC (NASDAQ:GBDC), PennantPark Investment (NASDAQ:PNNT), Hercules Technology Growth Capital (NYSE:HTGC), FS Investment Corp (NYSE:FSIC), Ares Capital (NASDAQ:ARCC), TCP Capital (NASDAQ:TCPC), THL Credit (NASDAQ:TCRD), New Mountain Finance (NYSE:NMFC) and Medley Capital (NYSE:MCC) please see:
- Part 1: Ares Capital
- Part 2: Medley Capital
- Part 3: TCP Capital
- Part 4: THL Credit
- Part 5: New Mountain Finance
- Part 6: FS Investment Corp.
- Part 7: Hercules Technology Growth Capital
- Part 8: PennantPark Investment
- Part 9: Golub Capital BDC
- Part 10: Gladstone Capital
Over the last four quarters PennantPark Floating Rate Capital (NASDAQ:PFLT) has had stable a portfolio yield of 8.1% and well below the average BDC (around 11.5%). When the CEO, Arthur Penn, was asked about portfolio yields going forward, he said:
"There is no question that there has been yield compression overall in the market. Fortunately for us again, PFLT is a relatively small player in a very large middle-market first lien world, so we can afford to be really picky. We don't come to the office every day and say how do we grow, we come to the office every day and say, can we find a good risk-adjusted return. So, so far we have been able to maintain our discipline both around credit as well as yields and we hope to continue to do so. And if that means we don't grow that means we don't grow, that's okay."
Its lower portfolio yield is due to having higher quality first lien senior secured investments and is one of the reasons it is a component in my suggested "Risk Averse" BDC portfolio.
On the recent earnings call, the CEO discussed the use of borrowings:
"As we have stated in the past our leverage targets are kind of 0.7 to 0.9 or 0.8 to 0.9, optimally, if we can get there. So we are getting close to optimally leveraged in our view. Obviously, we think first lien assets could be leveraged more and if there were a change in regulation, PFLT should be a big beneficiary of that. But at this point, with the 1:1 leverage constraint, we are getting fairly fully leveraged."
PFLT has a higher than average debt-to-equity ratio due to the quality of the portfolio and is approaching the upper limit of its targeted leverage as shown in the chart below.
Other income is not a significant amount and I have used the average for projection purposes. The base management fees for PFLT are among the most investor friendly and lowest in the industry at only 1.00% of gross assets a year paid quarterly and excludes idle cash. The incentive fee calculation is also beneficial for shareholders and though it has a lower hurdle of 7.00% of net assets, which is appropriate given its lower portfolio yield, there is not the typical "catch-up" after the hurdle. Most BDCs pay 100% of "pre-incentive fee net investment income" that is above the hurdle rate as a "catch-up" provision to pay the 20% income incentive fee to the investment adviser as shown in the diagram below.
PFLT has the same quarterly hurdle rate shown above but only pays 50% up to another hurdle of 2.9167% per quarter (11.67% annualized) and then 20% after that. This is a good thing for shareholders. For projection purposes I use core net investment income ("NII") that excludes both income and incentive fees related to capital gains.
The following table shows the results for the most recent quarter, along with projections at various levels of leverage and using a stable portfolio yield of 8.1% to determine the impacts on dividend coverage. Each of these scenarios assumes a full quarter of benefit from interest income but also a full quarter of interest expense, base management and income incentive fees.
These scenarios assume the highest level of efficiency and actual results could be lower because there will always be some turnover in the portfolio (that could drive higher fee income) and imply that the current dividend is sustainable if PFLT retains a higher amount of leverage and its portfolio yield.
Side by Side Comparison:
The goal of using a side by side comparison is to show an "apples to apples" view of each BDC with a stable portfolio yield, current cost structure and capital expenses with a portfolio that uses the same amount of leverage to increase return on equity investments. I will be using the amount of equity as of March 31, 2014 (or most recent) along with a debt-to-equity ratio of 0.80 and the current portfolio yield to project income and expenses, tracking the following metrics:
- Dividend coverage (using a debt-to-equity 0.80)
- BDC expenses (as a % of available income)
"Available income" is total interest and fee income less interest expense from borrowings and is the amount of income that is available to pay management expenses and shareholder distributions. BDCs with lower expenses can pay higher amounts to shareholders without investing in riskier assets.
The following table compares the results for PFLT to the other BDCs (so far in this series). As you can see PFLT has a much lower than average "operating cost as a percentage of available income" to match its lower portfolio yield. At this point I believe TCPC, HTGC and FSIC have a much higher potential for dividend increases than the average BDC. I will continue to add more companies in the following articles.
(click to enlarge)
For more details including some of the potential variances to this methodology for assessing dividend coverage, please see "Part 1" of this series. Investors should only use this information as a starting point for due diligence, and to learn more about PFLT please see "PennantPark Floating Rate Capital Articles."