PennantPark Floating Rate Capital Ltd. (PFLT) will benefit from the rise in interest rates since its portfolio is made up of 99% variable loans. This increase will support the stretched dividend payout ratio and management is committed to maintaining current dividend payments. This may make PFLT a potential target for income-seeking investors who want to receive a dividend on a monthly basis. However, the company is trading at its fair value and there are several risk factors such as the team of external advisors or not having the highest investment portfolio return. I’m neutral on the stock at the moment, but if the dividend yield is above 10%, I’ll consider a buy position.
PennantPark Floating Rate is a business development company. It seeks to make secondary direct investments, debt, stocks and loans. The company primarily provides senior debt. PFLT invests in middle-market companies located primarily in the United States with proven management teams, competitive market positions, strong cash flows, growth potential and viable exit strategies. The fund typically invests between $2 million and $20 million, their average investment size is $9.8 million. Their investment portfolio is spread across 45 industries across 110 companies. Their goal is capital preservation with a low risk portfolio, a steady stream of dividends and that’s why they have 86% of their portfolio in senior debt.
Finances and income
The company announced stable quarterly results without surprise. PFLT will announce its next quarterly result on February 9, 2022, after the financial markets close. PFLT recognizes income from two streams, but both are related to interest income. The majority of their income comes from interest on loans and the other source defined as other income consists of fees such as prepayment penalties, structuring, due diligence and advisory fees received from holding companies. In October 2021, PFLT also priced a public offering of an additional $85 million 4.25% note that can help refinance some of the company’s debt.
“PFLT continues to be well positioned as a leading provider of consistent and credible senior-tier capital for the core middle market. Due to the relative lack of competition in the core middle market, lenders can generally achieve higher returns with lower risk,” said Arthur Penn, Chairman and CEO.
Management invested heavily in new companies during the quarter ended September 30, 2021. It invested $185.7 million in 16 new portfolio companies and 18 existing companies. It’s a more diversified approach that management has taken for 2021 as, for the year ended September 30, 2021, a third of their investments went to new businesses compared to around 16% in 2020. However, the average return of Debt investments was only 7.4% compared to 8% in 2020. Currently, the total portfolio return is 7.4% at cost on a debt basis.
PennantPark Floating Rate is quite valued at the moment. It trades below book value and has a price-to-NAV ratio of 0.99. By comparing this figure to its peers, we can find better alternatives than PFLT. Apollo Investment (AINV) which is a similar BDC with over 90% of its portfolio in senior secured loans and almost all of them are floating rate loans trading 20% below its net asset value and BlackRock TCP Capital Corp. (TCPC) has 77% of its senior loan portfolio trading about 6% below its net asset value.
We find that inflation has had a slight impact on the fair value of the company’s investments due to the leverage it uses. However, the company is not hugely overleveraged, it has a regulatory net debt to equity ratio of 1.25x as of September 30, 2021. This fair valuation is also supported by the current dividend yield. It’s not exceptionally good or bad and the yield is close to the average yield in 2021. I would consider a blind buy with the same fundamentals above 10% but above 9.5% is a good opportunity for those who are into monthly dividend payments.
Company specific risks
In terms of market capitalization, PFLT is a medium-sized DBC with the 25th place out of the total of 48 publicly traded BDCs in the United States. The company cannot invest heavily in higher risk, higher return assets such as CLOs or subordinated debt. On the one hand, this is good news for investors, but if opportunities arise and the average return achieved on the total portfolio could be higher, their investment strategy limits the amount they can invest in these types of assets. The Fed’s interest rate hike will have minimal impact on PFLT’s portfolio, as 99% of their loans are variable rate loans, which may elevate their portfolio relative to other BDCs.
The company’s main risk factor is the team of external advisors. The Company depends on the access of PennantPark’s investment advisors to the investment information and deal flow generated by these experienced investment professionals. These managers of the Investment Advisor evaluate, negotiate, structure and monitor investments. In addition, advisors receive compensation based on net asset value, which could result in a conflict of interest. The future success of the business depends on the continued service of the management personnel of the Investment Advisor. The Investment Advisor has the right to resign at any time upon 60 days written notice, whether or not PFLT has found a replacement. In the event of an agreement termination, it is almost guaranteed that FPLT will have significant expenses to find a new adviser.
My take on the PFLT dividend
PFLT has been paying a stable monthly dividend for 10 years. Management is not known for extreme increases or reductions. They believe in a stable and consistent monthly payment. For over 5 years, the company has been paying $0.095 per share each month. This means that the company does not have a consecutive history of dividend growth, but to be fair among BDCs, consistently increasing dividends is not very common due to the cyclical nature of their business. Currently, PFLT yields just over 9% (9.09%).
The company’s payout ratio is pushed to the limits of approximately 100%. I would say this level is unsustainable going forward but it has been (even higher ratios) for many years. PFLT also issues notes to fund part of its operations and repay its debt and they do so with a fairly low yield, meaning that this money can also be used for dividends in the event of an economic downturn. I do not expect any increase in the dividend in 2022. However, I also expect management to maintain the current level and the dividend to be supported by the increase in the general interest rate.
PFLT may be ideal for investors who seek monthly dividend payouts and are willing to pay the price. The company is valued at fair value based on several technical factors and its net asset value has remained stable in 2021, with no major increases or decreases. Rising interest rates will help the company’s NII, but high inflation will hurt the fair value of their investments. I am not buying PFLT yet, but if the dividend yield exceeds 10% with fundamentals remaining the same, I will most likely open a position.