Patriot Capital Funding, Inc. Q2 2008 Earnings Call Transcript

Patriot Capital Funding, Inc. (PCAP)

Q2 2008 Earnings Call

August 5, 2008 10:30 am ET

Executives

Richard P. Buckanavage - President, Chief Executive Officer and Director

Timothy W. Hassler - Chief Investment Officer and Director

William E. Alvarez, Jr. - Chief Financial Officer, Executive Vice President and Secretary

Analysts

Jon Arfstrom – RBC Capital Markets

John Hecht – JMP Securities LLC

Vernon C. Plack, CFA – BB&T Capital Markets

Presentation

Operator

Welcome to the Patriot Capital Funding 2008 second quarter results conference call. (Operator Instructions) I would now like to turn the conference over to Richard Buckanavage, President and CEO.

Richard P. Buckanavage

This is the conference call to discuss the results for Patriot Capital Funding for the quarter ended June 30, 2008. I have with me this morning Tim Hassler, Chief Investment Officer and Bill Alvarez, our Chief Financial Officer.

Before we begin the call, Bill would you please provide our Safe Harbor disclosure statement?

William E. Alvarez, Jr.

Today's conference call is being recorded and webcast live through our website at www.PatCapFunding.com. An archive of today's webcast will also be available on our website as will an audio replay of the conference call. Replay information is included in our press release today and is posted on our website. Please note that this call is the property of Patriot Capital Funding Inc. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

I would like to call your attention to the customary Safe Harbor disclosure in our press release today regarding forward-looking information. Today's conference call includes forward-looking statements and projections and we ask that you refer to our most recent filings with the SEC for important factors that would cause actual results to differ materially from these projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings please visit our website or call Investor Relations at 212-835-8500. Lastly there will be a question-and-answer session following our presentation.

With that I'll turn it back over to Rich.

Richard P. Buckanavage

We continue to witness the effects of the ongoing retrenchment in the credit and financial markets. During the quarter we experienced much of the same trends from the first quarter. While our average pipeline during the second quarter was higher than that of the first quarter again deal flow quality was inconsistent, transactions fell apart at record rates and closing timeframes for those transactions fortunate enough not to have collapsed extended further. Our business also continued to be impacted by what we have been referring to as the single lender phenomenon. Because of all of these factors we were not able to identify and win any financing mandates in our core market segment that closed during the second quarter.

Our ability to grow the portfolio was further hindered by the full repayment of two proprietary investments, Cheeseworks and Innovative Concepts in Entertainment which totaled approximately $26 million in the aggregate. While this impacted our ability to grow the portfolio during the quarter we were not altogether disappointed by these events. These two investments by far represented our two lowest yielding assets. Our shareholders should benefit from higher profitability as we successfully recycle these proceeds into higher yielding investments.

In addition to the repayment of two of our proprietary investments we also received the full repayment of our $2 million commitment to Metrologic Instruments a syndicated debt investment we closed in the second quarter of 2007. Proceeds received upon repayment of the first and second lien term loan investments were equal to our total cost and in the case of the second lien term loan we also received a 1% early prepayment fee. This is contrast to a blended fair value of approximately 89% of cost immediately prior to its repayment. This outcome supports our assertions regarding the expectation for full cost recovery from many of our syndicated investments despite current depressed trading prices in the syndicated market.

As a result of the foregoing as we discussed during last earnings call we have actively sought investment opportunities in the broadly syndicated debt markets to offset sluggish growth in our core market segment. During the second quarter we committed to $16 million in syndicated debt transactions. Because may of these secondary trades require borrower approval and we have very little leverage over the borrower to move that process along faster. Only $2 million of these investments actually closed during the second quarter. Another $2 million closed subsequent to quarter end and we expect the remaining $12 million will close in short order and we should begin to see the benefits in the third quarter along with additional syndicated commitments we might make this quarter.

Given the operating environment presented to us today in our core market we will continue to actively seek investment opportunities in the syndicated debt market of between $12 million and $15 million per quarter. We continue to believe this strategy has material benefits for our shareholders. We will be able to create more granularity and additional diversification in the portfolio across asset class, obligor and industry. Sustained growth in the portfolio will allow us to continue to leverage our overhead and this initiative will also help to mitigate the effects of the increase in our debt funding costs.

Because of the lack of meaningful improvement in our core market during the first half of this year we are pushing out our own deployment expectations and do not expect a material increase in deployment activity in our core market until 2009. As such we expect that syndicated debt investments will represent a material portion of our overall portfolio growth through year end. As a result of the foregoing portfolio activity we ended the quarter with 31 portfolio companies totaling approximately $322 million at fair value. While we had the emergence of a five rated investment and subsequent to quarter end placed this on non-accrual status we had improvements in other categories that resulted in a modest improvement to our overall portfolio weighted average risk rating which stood at 2.08 at quarter end June 30, 2008 as compared to the first quarter of 2008 of 2.12 and fiscal year end December 31, 2007 of 2.11.

It is important to note that our total watch list assets remain below 25% of our total loan portfolio. We have only one non-accrual loan. Our four and five rated category is limited to all of one investment along with portions of only two additional investments and we actually saw a decline on a dollar basis in our most serious underperforming assets defined as category four and five of approximately $1.4 million. We are satisfied with the performance of our portfolio and these metrics are an acceptable range for a matured portfolio of this type and are within our own internal parameters. During the quarter we recorded net unrealized depreciation on our investments in the amount of approximately $3.4 million comprised of unrealized depreciation of approximately $5.3 million and our non-affiliate non-control and affiliate categories offset by unrealized appreciation of approximately $1.9 million in our control category.

Almost the entire $5.3 million of unrealized depreciation is attributable to only two investments rather than a broad based decline in credit quality. We believe our investment history and valuation practices along with the current portfolio metrics should provide shareholders with comfort despite these turbulent times. Realized losses on total commitments from inception to date is less than 1%. We currently only have one non-accrual loan and only three investments comprised our lowest two rating categories and even with the uptick in unrealized depreciation including the impact of the implementation of SFAS 157 portfolio fair value represents 95.3% of costs.

Turning my attention to the right side of the balance sheet the company has a solid liquidity position and modest balance sheet leverage of approximately .55 at quarter end. As you are aware on April 11^th, 2008 we increased the amount of our securitization revolving credit facility to $225 million and extended its maturity to April, 2011. With approximately $116 million outstanding under our debt facility at quarter end and access to approximately $209 million under the $225 million commitment we have approximately $93 million of capacity to fund future investment activities. As this is the lowest cost and most efficient capital available to us we would expect to utilize our securitization revolving credit facility to fund future growth for the foreseeable future.

The last formal remark I’d like to make this morning is to reiterate the announcement from last Friday that our Board of Directors after completing its process of estimating our distributable income for the third quarter of 2008 declared a dividend of $0.33 per share. The record date is September 12^th, 2008 with the actual dividend being paid on October 15^th, 2008.

I’d like to now turn the call over to Bill Alvarez who will discuss our earnings release for the quarter in more depth.

William E. Alvarez, Jr.

I will start with a discussion of our June 30, 2008 balance sheet. We ended the quarter with total assets of $335.1 million. Total debt outstanding was $116.1 million and total stockholder’s equity was $208.6 million and our debt to equity ratio was approximately .55 to 1. At quarter end our total investment portfolio at fair value totals $322.4 million down 16.2% from $384.7 million since the end of 2007 and up approximately 10% from $293.7 million at June 30, 2007 a year ago. The primary reason for the decrease in our portfolio during 2008 which totaled $62.3 million related to investment repayments and sales totaling approximately $62 million, unrealized depreciation of $13.2 million offset by net pick additions of $2.9 million and approximately $10 million of new or increased commitments on existing portfolio companies.

The weighted average yield on our interest bearing portfolio was 12.3% for the 2008 quarter and six months which increased slightly since the fourth quarter of 2007. Our weighted average fair value balance of our interest bearing investment portfolio during the quarter ended June 30, 2008 was approximately $337 million as compared to $363 million during the first quarter and $342 million in the fourth quarter of 2007. At June 30, 2008 our NAV was $10.08 per share down from $10.22 at March 31, 2008. The NAV decrease during the quarter by $0.14 primarily due to recording unrealized depreciation on our investments offset by an increase in unrealized appreciation on our interest rate swaps during the quarter.

Now let’s move on to a discussion of our 2008 second quarter earnings. Total investment income for the 2008 quarter was $10.7 million which was an increase over the $9.1 million of investment income during the 2007 comparable period an increase of approximately 17% and a slight decrease from the $11.2 million in the first quarter of 2008. Investment income increased in 2008 primarily as a result of the $29 million net growth in our investment portfolio since June 30, 2007. Included in investment income are fees and other income which total $523,000 compared to $253,000 in the first quarter of 2008. Total operating expenses were $4.2 million in the second quarter as compared to $4.5 million in the 2008 first quarter. Our total expenses decreased by approximately $300,000 due to lower compensation and interest expense partially offset by increased professional, general and administrative expenses. Our weighted average borrowings during the second quarter of 2008 were $139.6 million compared to $152.7 million during the first quarter of 2008.

Our net investment income was $6.4 million or $0.31 per basic and diluted share for the second quarter of 2008 as compared to $6.8 million or $0.33 per basic and diluted share in the first quarter of 2008. During the second quarter of 2008 we recognized net realized losses of $344,000 principally due to the cancellation of warrants for which we had previously recorded as unrealized deprecation on the entire warrant balance. Net unrealized depreciation for the second quarter of 2008 was $3.4 million compared to net unrealized depreciation of $9.9 million in the first quarter. The components of the unrealized depreciation during the second quarter of 2008 resulted from the following, $217,000 of unrealized depreciation from quoted market prices on our syndicated loan portfolio and approximately $3.6 million from a decline in cash flow of our portfolio companies requiring closer monitoring offset by approximately $452,000 of unrealized appreciation resulting from the effects of SFAS 157.

At June 30, 2008 we had approximately $4 million of unrealized depreciation on our investments resulting from our implementation of SFAS 157 most of which was recorded during the first quarter. Our belief is that the majority of the $4 million of unrealized depreciation will ultimately be reimbursed is supported by the fact that all such unrealized depreciation related to investments we rated one or two under our investment rating system. Net unrealized appreciation on our interest rate swap agreements totaled $1 million in the second quarter of 2008 compared to unrealized depreciation of $753,000 in the first quarter. Our net income for the second quarter of 2008 was $3.7 million or $0.18 per basic and diluted share as compared to a net loss in the first quarter of 2008 of $3.9 million or $0.19 per basic and diluted share. At June 30, 2008 we did not have loans or debt securities at fair value not accruing interest. However in July we placed one of our portfolio companies on a non-accrual status.

And now I’ll turn things over to Tim Hassler, our Chief Investment Officer.

Timothy W. Hassler

Through the first half of this year the competitive landscape in the lower middle market has been challenging. While we believe there are fewer participants actively pursuing transactions in our market there have also been a lot fewer quality transactions to pursue. As a result the competitive landscape has intensified for the limited number of quality deals and we’re being routinely outbid. While current leverage multiples are a quarter to a half turn below the peak levels seen in early to mid-2007 pricing is as aggressive as we’ve seen it in our market especially in the mezzanine asset class.

Through July we’ve reviewed over 300 transactions which is a 20% increase compared to last year but as I mentioned before the quality of companies continues to be underwhelming. However with our solid liquidity position we are aggressively pursuing the highest quality companies that we see and we currently have one signed mandate and one verbal mandate each for $20 million. Given the extended timeframe to close transactions in the current environment we currently anticipate that these mandates could turn into closed deals in the late third quarter or early fourth quarter. Both transactions are priced to yield IRRs at or above our current portfolio returns.

As I’ve mentioned in previous calls we continue to be keenly focused on credit quality as we review new transaction opportunities and manage our existing portfolio. With a conservative asset mix of nearly 50% senior secured debt and solid industry diversification we believe the portfolio is well positioned to weather the current economic downturn but we have started to see weakness in certain industries such as consumer discretionary, capital equipment and construction. Most of the manufacturers in our portfolio have also seen substantial raw material price increases that have been difficult to fully pass through to their customers. Despite these pressures our weighted average portfolio rating improved slightly in the second quarter and the fair value of the portfolio is still over 95% of cost which we believe is a testament to our sound underwriting and the conservative capital structures we put in place at the outset of our deals to provide cushion for the challenges that these smaller companies face.

Now I’m going to turn it back over to Rich.

Richard P. Buckanavage

That concludes our prepared remarks this morning.

Question-And-Answer Session

Operator

(Operator Instructions) Our first question comes from Jon Arfstrom – RBC Capital Markets.

Jon Arfstrom – RBC Capital Markets

Couple questions for you, can you talk a little bit about the return potential comparing contrast to syndicated loan opportunity, what you’re seeing there versus the traditional business?

Richard P. Buckanavage

Jon, as you know from last earnings call we are for the most part investing in secondary purchases on the syndicated market so these are loans that have been done in previous periods and we are purchasing these assets at a substantial discount so the overall yield is comparable to the portfolio but we get there by a different means. The cash return is lower than our core investment assets but when we include the benefits of OID into those investments, we get back to the same spot. As we’ve said in prior calls, we do think there’s some upside there as some of these assets repay early, we should get a potential pop on the OID as we perhaps shell all that OID in a shorter period. The comparison to the core assets is based on a yield to maturity basis.

Jon Arfstrom – RBC Capital Markets

The next question is on funding, you talked about having $93 million of [inaudible] capacity and obviously when you pencil out the growth, that means that you don’t have to tap the equity market for quite a while if you just rely on that funding availability. The question is how do you think about your ability to issue stock at the low NAV with where your stock is trading right now and with other scenarios where that is on or off the table?

Richard P. Buckanavage

We wouldn’t find issuing equity at these levels prudent and as you point out, we have more than adequate liquidity which is a far better capital and lower cost capital than issuing equity. We don’t see that as being an option for the foreseeable future. We did seek that approval through our proxy process as additional flexibility but at this point in time given the deployment environment and given our liquidity position we wouldn’t expect to utilize that particular feature.

Jon Arfstrom – RBC Capital Markets

Just the last question, can you talk a little bit more about the new non-accrual credit, the size of it and what kind of collateral backs that loan?

Richard P. Buckanavage

We gave the amount $545,000 of income for the first six months which represents about $0.025 per share of income. As far as collateral goes, there is some collateral supporting that investment. It’s typical for the investment that we make generally not fully collateralized. The portion that is not collateralized sits in the five rated bucket. The senior most portion of that transactions sits in our four rated category given its collateral coverage.

Operator

Our next question comes from John Hecht – JMP Securities LLC.

John Hecht – JMP Securities LLC

I want to make sure I understand the changes in valuations during the quarter, you had about a 2.2 unrealized depreciation in the non-control affiliate. Can you tell me what the composition of that was?

Richard P. Buckanavage

In what respect, John?

John Hecht – JMP Securities LLC

Are any of these from syndicated loan market that might have been changing in value or are these more specific company investments?

Richard P. Buckanavage

The changes in syndicated loans would show up in that category but it was fairly modest depreciation in the syndicated loan during this quarter.

William E. Alvarez, Jr.

$217,000.

Richard P. Buckanavage

$217,000 was attributable to the syndicated, so if you back that out the remainder would be depreciation in our core investments for non-control non-affiliate.

John Hecht – JMP Securities LLC

You mentioned a decline in bucket four and five in terms of the number of investments that were in those buckets. Can you characterize the work out process and what the remaining assets in those? Are you in discussions with private equity groups for potential recapitalizations and how does that process feel to you at this point?

Richard P. Buckanavage

Right now in the three assets that are comprised of our lowest two ratings we are engaged in active dialog with all of the sponsors involved in those transactions. As obviously we hope that is the case. You’ve heard us mention time and time again when you’re working collaboratively with a sponsor you’re going to achieve a better outcome, something along the lines of the Encore situation. The three that we’re working on we think the ratings reflect the status of the financial performance. We’re working diligently with the sponsors to come up with a solution, maybe a recapitalization among other things to improve those situations. But one of which fell to a point where we didn’t feel it was prudent to maintain its accrual status and we’ve now put that on non-accrual as of 7/1.

John Hecht – JMP Securities LLC

The final question would be you talked about the $16 million in syndicated transactions you’re going to invest in and you discussed the increasing competition in the primary market is the higher quality potential investments are just not attractive in their returns right now. Is there anything in your pipeline, sort of more specific company investment that is interesting or are you more just on the sidelines now until the market normalizes?

Richard P. Buckanavage

I think there’s a number of transactions that are appealing to us from a return perspective but what we are seeing is that the higher quality transactions are getting bid aggressively. It’s a bit ironic that we talk in the context of a credit crisis when we talk about aggressive lending practices. I think it’s just the case of there being fewer players and less capital available in our marketplace but the rate of decline of the number of quality transactions has far outpaced the decline in capital. So we still unfortunately have an environment where we have too much capital chasing too few deals. That being said, it’s not every deal. Where those deals, even for quality deals, where they’re being bid a lot of it has to do with the type of business. Clearly people are focused on what are perceived as recession resistant type credits more aggressively than companies that operate in cyclical end markets, companies with greater collateral coverage obviously are going to garner a more aggressive proposal in this marketplace. Obviously leverage plays into that as well. Certainly the sponsor plays into it as well. The more well banked the sponsor is, generally the more aggressive the resulting bid is going to be on the debt side.

So there’s a variety of factors that go into the relative aggressiveness of the bid in this market, but overall we’re definitely seeing pricing reign in from where we were just at the beginning of the first quarter, as Tim mentioned particularly in the mezzanine asset class.

Timothy W. Hassler

John, just to reiterate we do have two mandates in our core market worth about $40 million in total.

John Hecht – JMP Securities LLC

The last to get a little color, what are you seeing in terms of pricing and leverage right now versus last quarter and what would levels have to come to before you begin the valuate this as a more attractive market?

Richard P. Buckanavage

I think we’re not as, I guess, pessimistic about leverage. Leverage has fallen by a quarter, a half a turn probably into the mid-three’s, maybe to the upper threes. We’re comfortable with where the leverage multiples are, although I think they probably have another quarter turn to go where we would find it attractive versus neutral. From a pricing perspective I think is where we’ve had the most challenges. We have seen probably a contraction in the mezzanine asset classes anywhere from 100 to 200 basis points just in the last quarter as people chase deals. In the senior side, I would say anywhere from 50 to 100 basis points of contraction. It’s moving in the wrong direction at the very time that we think it should be expanding, not contracting. It’s a little frustrating for us. We’re not going to chase deals for the sake of chasing deals. We’re not going to grow the portfolio and misprice risk. But as Tim just alluded to, we do have two mandates and we still are finding our spots, we’re just finding fewer spots than we have historically.

Operator

Our next question comes from Vernon C. Plack, CFA – BB&T Capital Markets.

Vernon C. Plack, CFA – BB&T Capital Markets

My question, Rich, relates to leverage on your balance sheet and with the funding that you have available, just curious in terms of how much you do want to leverage your balance sheet, in this type of environment where do you see your debt to equity ratios maxing out at all else the same?

Richard P. Buckanavage

I don’t know if it’s changed all that much, Vernon. I think leverage is going to be dictated around drawing on the debt facility to make attractive investments and if we obviously don’t find attractive investments, leverage is going to stay in a fairly modest range similar to where it is today. I would say that clearly with the flexibility that we have we probably can operate a little bit higher than maybe historically, maybe closer to .8, .85 to 1 with the flexibility that the approvals gave us. But again that would indicate that we’re seeing a pretty material uptick in deployment which we don’t see right now. The pipeline is up but the actual deployment rate is obviously substantially down.

Vernon C. Plack, CFA – BB&T Capital Markets

It really relates to more of a liquidity question as well, just gauging how you’re going to manage the capital that you have available. I wanted to see if we could get any more color on the appreciation in the portfolio as a result of FAS 157? Can you provide me with any more details on that please?

Richard P. Buckanavage

Sure, Vernon, that’s just simply a decline in the benchmarks or the referenced security that we use to evaluate the portfolio based on market parameters. You’re going to see that number move around from plus or minus depending on what’s going on in the marketplace. In this particular quarter given what we just discussed in the marketplace, the reference group declined which means that the assets that are yielding less than the reference group are yielding less than they were last quarter, hence the write up on those pool of assets.

Operator

Mr. Buckanavage, there are no further questions at this time.

Richard P. Buckanavage

Thank you everyone. We appreciate your attendance this morning and we look forward to speaking again in the fall to discuss our third quarter results.

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