Fitch Places PennantPark's 'BBB-' Ratings on Rating Watch Negative.
The rating action follows PNNT's Nov. 16, 2018 announcement that it plans to redeem its unsecured bonds, which are scheduled to mature in October 2019, in early 2019 and that it received approval from its board of directors to reduce its asset coverage requirement to 150% from 200%. This approval will effectively allow the firm to increase its leverage ratio to a maximum of 2.0x from 1.0x, effective Nov. 13, 2019. However, the company also plans to seek approval from its shareholders to reduce asset coverage at its annual meeting in February 2019, which if approved, would allow the company to increase leverage more quickly (subject to the amendment of bank credit facility covenants). In concert with the asset coverage change, the board approved a reduction in PNNT's base management fee to 1.0% from 1.5% for assets financed using leverage above 1.0x.
KEY RATING DRIVERS
IDR AND SENIOR DEBT
The Rating Watch Negative reflects the expected reduction in PNNT's financial flexibility, following the repayment of its unsecured debt in early 2019, and the potential for higher leverage, given the approved asset coverage reduction, both of which Fitch believes are incrementally negative for the firm's credit profile.
PNNT's ratings remain supported by its strong long-term track record in credit, experienced management team, sufficient liquidity and strong historical dividend coverage. PNNT's ratings remain constrained by above-average exposure to non-senior debt and equity investments relative to peers, elevated energy exposure and higher-than-peer leverage. Over the longer term, Fitch also believes PNNT's lack of affiliation with a broader investment platform could be a headwind, should bank financing become more constrained for the sector.
Rating constraints for the BDC sector include the capital markets impact on leverage, given the need to fair value the portfolio each quarter, dependence on access to the capital markets to fund portfolio growth, and a limited ability to retain capital due to dividend distribution requirements. Additionally, the competitive underwriting environment has yielded deterioration in middle market underwriting and loan terms, including fewer/looser covenants, higher underlying leverage and tighter spreads. The recent increase in maximum regulatory-permitted leverage to 2.0x from 1.0x, could also adversely affect industry competitive dynamics and increase the risk profile of certain BDCs, but may also afford BDCs with additional covenant cushion. Fitch believes this backdrop could contribute to asset quality deterioration in the sector when the cycle turns.
PNNT's planned redemption of its $250 million, 4.5% unsecured debt in early 2019 will eliminate its unsecured funding component, which Fitch believes reduces the firm's financial flexibility in times of stress. Fitch expects the unsecured debt, which will be redeemed at par with a make-whole premium, will be refinanced with borrowing capacity on PNNT's $445 million secured revolving facility. Fitch generally expects BDCs rated in the 'BBB' category to have unsecured debt represent 35%-50% of total debt (PNNT was at 49% at FYE18). As a result, the absence of unsecured debt in PNNT's funding profile is expected to result in a one-notch downgrade of the ratings when the debt is repaid.
PNNT's leverage, defined as gross debt (at par) to equity, was 0.81x at Sept. 30, 2018, which remains above the peer group average. The board's approval to reduce asset coverage requirements to 150% will allow PNNT to increase leverage above 1.0x in November 2019, or sooner, should shareholder approval be received in February. While management has not yet disclosed a new long-term leverage target, Fitch would view an increase in leverage negatively, given the current portfolio profile, which includes outsized exposure to legacy energy investments and above-average exposure to second lien and equity investments.
PNNT's exposure to oil and gas and energy and utilities companies continues to be elevated relative to peers, which historically contributed to realized credit losses in the portfolio. On a combined basis, energy investments amounted to 12% of the portfolio at fair value, as of Sept. 30, 2018, the same as a year ago. Exits of PNNT's energy positions may take time to resolve, and commodity price movements and/or company-specific challenges could yield incremental valuation hits and eventual realized credit losses.
There were no non-accruals as of Sept. 30, 2018. While there are no indications of broader credit issues in the portfolio, Fitch believes PNNT's higher exposure to second-lien, subordinated, and equity investments relative to peers may expose the firm to heightened asset quality issues should economic conditions weaken. Management has committed to rotating the portfolio into more senior loans and to monetize its equity positions over time, which Fitch views favorably. However, this may take time to effect. Despite the challenges in energy, Fitch believes PNNT has a strong track record in credit. Since inception, only 12 out of 208 of PNNT's investments have been placed on non-accrual status, with an average recovery of 80%.
Operating performance continues to be pressured, given portfolio rotation and competitive market conditions. Core net investment income (NII) in fiscal year 2018 (FY18) ended Sept. 30, 2018 was down 5.5% from a year ago, driven by a lower yielding portfolio partially offset by a decrease in debt-related expenses and base management fees. The weighted average portfolio yield was 11.2%, at cost, at Sept. 30, 2018; down 30 bps yoy.
Pressures on revenues were partially offset by a 50 bps reduction in base management fees, to 1.5% of gross assets and a reduction in incentive management fees to 17.5% (from 20%) subject to a 7% hurdle rate, beginning Jan. 1, 2018. The further reduction in the base management fee rate to 1.0% for assets financed with leverage above 1.0x is consistent with peers that recently pursued asset coverage reductions, and could ensure stronger dividend coverage over the medium term.
PNNT's liquidity consisted of $19.5 million of balance sheet cash, $364.5 million of available capacity under its revolving credit facility, subject to borrowing base requirements, and $120 million of available capacity under the SBA facilities at Sept. 30, 2018. Cash flow from principal repayments and investment sales amounted to $630.5 million in FY18, up from $544.0 million in the prior year. PNNT's only near-term debt maturity is the $250 million of senior unsecured debt coming due in Oct. 1, 2019, which Fitch expects will be repaid in early 2019 with revolving facility borrowings.
NII coverage of the dividend was solid in FY18, amounting to 104.6%. The dividend is further supported by the presence of spillover income of $0.30 per share, as of Sept. 30, 2018.
The secured debt rating is equalized with the long-term IDR, reflecting PNNT's relatively low leverage and average recovery prospects under a stress scenario.
The alignment of PNNT's unsecured debt rating with its IDR and secured debt rating has historically reflected the meaningful proportion of unsecured debt in the funding profile and the relatively low level of firm leverage, which suggested average recovery prospects for all classes of debt under a stress scenario. Fitch now expects PNNT's unsecured debt will be paid in full in early 2019, given the redemption announcement, which will result in the withdrawal of the unsecured rating at that time.
IDR AND SENIOR DEBT
Fitch expects to downgrade PNNT's ratings by at least one notch following the redemption of its unsecured debt in early 2019, as the firm's financial flexibility will be weakened without an unsecured funding component.
Further negative rating actions could be driven by an increase in the firm's leverage target, given the approval to reduce asset coverage requirements, without a commensurate decline in the risk profile of the portfolio. Negative rating actions could also result from outsized portfolio growth, a spike in non-accrual levels, resulting in meaningful realized losses, or weaker cash dividend coverage and/or an inability to maintain sufficient cushions to asset coverage to account for valuation volatility. Longer term, should PNNT's lack of affiliation with a broader investment management platform affect its asset sourcing and/or funding flexibility, ratings could also be pressured.
Ratings could be removed from Rating Watch Negative and affirmed at 'BBB-' if the company elects to maintain unsecured funding in excess of 35% of its funding profile and any leverage increase is accompanied by commensurate improvement in asset quality including a reduction in non-yielding equity investments, an increase in senior debt investments and increased portfolio diversity.
The secured debt rating is primarily linked to the Long-Term IDR and is expected to move in tandem. Fitch would not expect to maintain the unsecured debt rating once the existing notes are paid in full early next year.
Headquartered in New York, NY, PNNT is an externally managed BDC, formed in 2007 with an objective to generate both current income and capital appreciation through debt and equity investments. As of Sept. 30, 2018, the company had investments in 53 portfolio companies across 27 industries with a fair value of approximately $1.1 billion.
Fitch has placed the following ratings on Rating Watch Negative:
PennantPark Investment Corporation
--Long-Term IDR of 'BBB-';
--Senior secured debt of 'BBB-';
--Senior unsecured debt of 'BBB-'.