Fitch Ratings has affirmed the long-term Issuer Default Rating (IDR),
secured debt and unsecured debt ratings of PennantPark Investment
Corporation (PNNT) at 'BBB-'. The Rating Outlook has been revised to
Negative from Stable. Today's rating actions have been taken as part of
Fitch's periodic peer review of Business Development Companies (BDCs),
which comprises 10 publicly rated firms.
BDC INDUSTRY OUTLOOK
Fitch's outlook for the BDC sector is negative; reflecting competitive
underwriting conditions, earnings pressure, underperforming energy
investments, unsustainable asset quality metrics, increased activist
pressure, and limited access to growth capital. While some firms are
better positioned, given their more conservative financial profiles and
portfolio characteristics, others are likely to see rating pressure over
the outlook horizon.
BDCs are heavily dependent on the equity markets to fund portfolio
growth, but access to the market has been almost non-existent over the
last 18 months as share prices continue to trade at steep discounts to
net asset value (NAV). At March 7, 2016, rated BDCs were trading at a
18.3% average discount to NAV, thus preventing most from issuing stock
without significantly diluting existing shareholders. While the
reduction in portfolio growth is viewed favorably by Fitch, given tough
underwriting conditions, some firms may struggle to close the trading
gap, leaving them at a competitive disadvantage if and when investment
opportunities arise.
The decline in commodity prices has yielded the first notable crack in
asset quality performance for BDCs. More broadly, asset quality metrics
remain at unsustainably low levels, in Fitch's opinion. While strong
portfolio company performance has been supported by an improving
economic environment, low interest rates are likely masking some
potential underlying company-specific issues, as issuers have been able
to refinance themselves out of trouble rather easily in recent years.
Fitch believes asset quality metrics are likely to deteriorate over the
near term; however, the pace of deterioration will be somewhat dependent
upon the rate of change in interest rates, the backdrop of the broader
economic environment, differing sector exposures, and the integrity of
individual firms' underwriting.
Fitch has not observed a marked increase in leverage levels for the
sector, with average leverage for investment grade-rated BDCs of 0.74x
at year-end 2015 compared to 0.60x at year-end 2014. However, there is a
wide dispersion of leverage around the average, and those with the most
energy exposure often also have the highest leverage ratios. Share
repurchase activity has also increased in the sector in recent quarters,
which could inflate leverage ratios further. Fitch believes that BDCs
heavily focused on maximizing leverage run the risk of having less dry
powder to deploy when if and when underwriting conditions improve, thus
weakening earnings upside.
KEY RATING DRIVERS
IDRS AND SENIOR DEBT
The revision of the Rating Outlook to Negative from Stable reflects
outsized exposure to oil and gas investments, which has resulted in
modest net realized portfolio losses, meaningful net unrealized
depreciation, an increase in non-accrual levels, and a decline in net
investment income (NII), which are pressuring dividend coverage and
inflating leverage. Given the relatively higher levels of GAAP leverage,
PNNT has less of a cushion relative to peers against potential NAV
declines resulting from broad market movements or specific portfolio
company underperformance.
The rating affirmations reflect PNNT's consistent operating performance,
strong track record in credit throughout the recent financial crisis,
solid liquidity with no near term debt maturities, low interest rate
risk, strong dividend coverage, historically, and an experienced
management team.
Rating constraints include PNNT's above-average exposure to mezzanine
and subordinated debt relative to peers, elevated energy exposure, the
capital markets impact on leverage, given the need to fair value the
portfolio each quarter, dependence on the capital markets to fund
portfolio growth, and a limited ability to retain capital due to
dividend distribution requirements.
Fitch considers PNNT's exposure to energy to be elevated relative to
peers. On a combined basis, energy investments amounted to approximately
16% of the portfolio at cost, as of Dec. 31, 2015, well above the peer
average of 9.9%. Further market movements or company-specific challenges
could yield incremental valuation hits and eventual credit losses should
energy prices remain at current levels.
Fitch conducted a stress test on BDC energy exposures and believes
PNNT's leverage is among the most vulnerable in the peer group. A stress
on the overall energy portfolio, based on Dec. 31, 2015 balances yields
GAAP leverage of 1.18x and regulatory leverage, excluding Small Business
Administration (SBA) debt, of 0.89x, which remains within the 1:1 limit.
PNNT's energy exposures are primarily first- and second-lien positions,
which could moderate risk of loss.
GAAP leverage, as measured by total debt to total equity, inclusive of
SBA debt, amounted to 0.95x as of Dec. 31, 2015, which exceeded
management's long-term target of 0.6x-0.8x and is well-above the peer
group average. Regulatory leverage, which excludes SBA debt, amounted to
0.72x as of the same date. While management represented to Fitch that it
remains committed to its long-term target, leverage is likely to remain
elevated over the near term, as the firm balances SBA originations,
share repurchases, and the potential for incremental portfolio
write-downs. A meaningful decline in PNNT's asset coverage ratio (242.2%
at Dec. 31, 2015), resulting from outsized share repurchase activity or
broader portfolio credit issues, would likely yield a ratings downgrade.
In May 2015, the board authorized a share repurchase plan to acquire up
to $35 million of its common stock at prices below NAV until May 6,
2016. During the period ended Dec. 31, 2015, the firm repurchased 3.3
million shares at a weighted average price of $6.93 per share for an
aggregate cost of $26.3 million. After the repurchases, PNNT has
approximately $8 million of authorization under the current program. As
of Dec. 31, 2015, PNNT was trading at $6.18 per share, representing a
31% discount to NAV of $9.02 per share, consistent among its peers in
the current environment where BDC shares have been trading at an average
discount of 18.3% to NAV. While Fitch understands the motivation of the
stock buyback given the current share price discount, meaningful
repurchase are viewed unfavorably given the current leverage levels. In
addition, leverage could be further impaired by incremental credit
issues in the portfolio or volatility in portfolio valuations, given
market spread widening. Fitch would view a reduction in debt, via
portfolio repayment proceeds, favorably, as it would enhance the firm's
asset coverage cushion.
Asset quality trends have deteriorated modestly over the past year, with
three investments on non-accrual status as of Dec. 31, 2015,
representing 5.4% of the investment portfolio at cost, and 1.2% at fair
value, with one material oil and gas investment moving to non-accrual
status in the first quarter of 2016 (1Q16). While there are no
indications of broad credit issues in the portfolio, Fitch believes
PNNT's relatively higher exposure to second lien and subordinated debt
may expose the firm to heightened asset quality issues should economic
conditions weaken. That said; management has a demonstrated track record
working out problem loans. Since inception in 2007, PNNT had only 10
positions out of 175 investments go on non-accrual status. The firm had
successfully restructured all of its non-accrual investments, and
realized an average recovery of 79%.
PNNT's portfolio concentration is considered below average among
peer-BDCs, with the top 10 investments accounting for a manageable 39.7%
of total assets but a more elevated 79.8% of equity, as of Dec. 31,
2015, driven by the company's increased leverage. No single investment
accounted for more than 5.8% of assets during the same period.
Operating performance had remained relatively consistent over time,
despite the impact of competitive underwriting conditions on portfolio
yields, but is expected to decline in 2016 given an increase in
non-accrual levels. To help offset this, PNNT's advisor voluntarily
agreed to waive 16% of both base and incentive management fees, based on
the cost exposure of the energy portfolio for the first quarter ended
Dec. 31, 2015 through Dec. 31, 2016. In the December 2015 quarter, the
fee waiver amounted to $1.6 million, or roughly 10% of NII during the
quarter. Fitch views the fee waiver positively and believes it will help
cushion operating performance, as the energy portfolio continues to
underperform.
NII during the three months ended Dec. 31, 2015 amounted to $16.8
million, compared to $19.5 million during the comparable quarter
one-year prior. The modest decline was driven by the repayment of
higher-yielding investments, as PNNT moved up the capital structure to
more senior, first- and second-lien investments and an increase in
non-accruals during the quarter.
Given the decline in NII, coverage of the dividend amounted to 82.4% of
dividends paid in the quarter ended Dec. 31, 2015. Although PNNT did not
fully cover its dividend in the quarter, historical coverage has been
strong, averaging 108.4% since inception. Additionally, the current
dividend is supported by spillover income of approximately $0.56 per
share, which Fitch believes provides further stability to the dividend
over the medium term. Since inception, PNNT has not missed or cut its
dividend and management has represented that it is comfortable
under-earning its dividend temporarily if they are able to prudently
invest in the current underwriting environment. Still, over-distributing
income could further inflate PNNT's already high leverage ratio, but
gains expected from an equity realization in the second quarter may also
help to support the dividend in the near term.
Fitch views PNNT's liquidity profile as solid, with $26.3 million in
unrestricted balance sheet cash, and $402 million of availability under
its credit facility, subject to borrowing base requirements, as well as
$75 million of incremental borrowing capacity under its second SBIC, as
of Dec. 31, 2015. Cash flow from principal repayments and investment
sales amounted to $130.3 million, an 18% reduction compared to the same
period last year, as refinancing activity and prepayments slowed. Fitch
believes the pace of repayment could slow further in 2016, particularly
if loan yields increase.
PNNT's funding profile has improved over the years with the issuance of
retail notes and institutional unsecured debt. Unsecured debt
represented 52.3% of total debt outstanding, which is viewed favorably
by Fitch. There are no debt maturities until June and October 2019, with
the maturity of the corporate revolver and institutional notes,
respectively. Fitch expects PNNT will look to extend the maturity of the
revolver and refinance the institutional notes if market conditions are
supportive.
RATING SENSITIVITIES
IDRS AND SENIOR DEBT
PNNT's ratings could be adversely affected by a sustained increase in
GAAP leverage above the targeted range, driven by outsized share
repurchase activity or further deterioration in asset quality
performance, which results in sizeable net realized losses and/or net
unrealized depreciation. Material declines in operating performance,
broader portfolio credit issues, and/or weaker dividend coverage for a
sustained period would also be viewed unfavorably from a ratings
perspective.
The performance of mezzanine and subordinate investments in an
environment where asset quality reversion is expected bears monitoring,
as does the performance of PNNT's energy investments, particularly if
energy prices are sustained at current levels.
Revision of the Outlook to Stable would be dependent upon the successful
resolution of problem loans, improved operating performance, a reduction
in GAAP leverage to targeted levels, and strong cash earnings coverage
of the dividend. Rating stability could also be supported by solid
credit performance of post-crisis vintage loans.
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 Dec. 31, 2015,
the company had investments in 62 portfolio companies with a fair value
of approximately $1.3 billion.
Fitch has affirmed the following ratings:
PennantPark Investment Corporation
--Long-term IDR at 'BBB-';
--Senior secured debt at 'BBB-'
--Senior unsecured debt at 'BBB-'.
The Rating Outlook is Negative from Stable.
Date of Relevant Committee: March 8, 2016.
Additional information is available on www.fitchratings.com
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
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https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1000679
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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