PFLT: Is This 10% Dividend Income Suitable For You

About BDCs

Recently, the Fed hiked rates to an eye-popping 5.00% – 5.25% in an effort to combat inflation. This is a boon to investors, who have access to risk free high yield savings accounts that pass on this interest rate to savers. However, this party is not going to last long, as the Fed is eyeing inflation, waiting for it to fall back to ~2-3%, so that it can reduce rates to a meager 2-2.5%. Are there alternative ways to earn a high yield?

The BDC sector offers such an alternative. A BDC is a managed portfolio of leveraged middle market business loans. The typical middle market business loan yields around prime + 2.5%, and the leverage costs about the same as investment grade corporate debt. Leverage is typically limited to a debt to equity ratio of 1. After management fees and incentive fees, the rest of the returns go to the investor. The result is an attractive 8-10% dividend yield that represents substantially all of the return a BDC has to offer.

However, for long-term buy and hold investors, the BDC sector has its fair share of traps. There are 6 key areas an analyst must consider when considering investing in a BDC. They are:

• Are management & incentive fees in alignment with shareholders?
• Are balance sheet leverage levels reasonably close to a debt to equity ratio equaling 1?
• Do assets tend to be on the conservative side: emphasis on senior secured debt instruments, preferably with floating rates?
• How has credit quality been in recent years?
• How much does the BDC’s leverage cost?
• Is there wide diversification by industry, with tilt away from cyclical sectors of the economy?

This article will consider these six questions for PennantPark Floating Rate Capital (NYSE:PFLT).

Management Alignment With Shareholders

The bulk of fees charged by the management of a BDC are the base management fee and the incentive fee. The base management fee is typically a flat fee based on a % of total assets, while the incentive fee is meant as a target for the yield of the asset portfolio.

The base management fee at PFLT is equal to 1.00% of gross assets net of treasuries on an annual basis. This is lower than the typical management fee at BDCs, where 1.50% is the more common rate. Immediately, we can see that this is aligned with shareholder interests.

The incentive fee is computed differently. The hurdle rate that the asset portfolio must yield in order for the incentive fee to begin is 1.75% / quarter (or 7.00% / year). After that, 50% of returns are charged as the incentive fee. Then afterwards, 20% of any returns above 2.9167% / quarter (or 11.6668% / year) are additionally charged as the incentive fee.

This fee structure sets a 7% yield floor for the loans issued, and for asset portfolio yields beyond 11.6668%, management participates less in the incentive fee if they for yield beyond that.

Balance Sheet Leverage

We compute the debt to equity ratio for FY end 2014 – 2023 for PFLT. All figures used are in millions and were extracted from past 10-K filings. The debt to equity ratio is important for risk because a high ratio magnifies the effect of loan losses on the equity.

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The debt to equity ratio at PFLT has veered left and right over the past decade. It is currently close to 1, and prospective investors need to monitor the leverage at PFLT to make sure that it fits their risk tolerance. A soundly managed BDC should consistently have a debt to equity ratio of roughly 1.

Because of the lack of consistency here, I would disqualify PFLT as a long-term buy and hold investment. But let’s keep going anyway.

Asset Portfolio Seniority & Rate Structures

In BDC lending, the most conservative form of asset is the senior secured loan. This is the gold standard for BDC assets since it carries with it the greatest chance of recovery of principal should the debtor default on the loan.

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As a side note, PSSL stands for PennantPark Senior Secured Loan Fund I LLC. It is an unconsolidated venture between PennantPark and Kemper, and I believe it is a source of off-balance sheet leverage. Little is stated about PSSL in the 10-K, and so for the time being I believe that PSSL is a de-facto BDC, contained in PFLT, a BDC also.

About 85% of PFLT’s asset portfolio is senior secured debt. This means that for the asset book is formally quite conservative, a plus for investors.

As for how much of the asset portfolio is floating rate – well this one is kind of right in the name, PennantPark Floating Rate Capital. The 10-K states that PFLT expects its assets to be at least 80% floating rate. This is a good thing for investors, as floating rate assets have less value volatility when interest rates change: if the interest rate increases, the discount rate increases but the cash flows to be discounted also increase.

Credit Quality & Underwriting Results

BDCs are similar to banks in a fundamental way – earn yield on loans and pay costs on leverage. However, BDCs by law must pay out at least 90% of taxable income as dividends, leaving very little room for retaining earnings and boosting net asset value that way. This means that credit losses are hard to reverse.

To evaluate the underwriting at a BDC, I use what I call the “equity appreciation (depreciation) ratio”, which is Net Realized and Unrealized Gains (Losses) divided by total equity. We want this figure to be as positive as possible. A bad sign is if this number, averaged over time, is a negative number, as it would show that the BDC is incapable of protecting its net asset value over extended periods of time.

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The average equity appreciation / depreciation ratio for 2014 – 2023 was negative 1.222%. This means that averaged over a decade, PFLT lost about 1% of its net asset value from year to year. This is not a good sign, and in my personal book this overall negative number disqualifies PFLT for a long-term buy and hold investment. But for good measure, let’s keep looking at the two remaining aspects.

Cost Of Leverage

What PFLT avoids paying as interest expense goes straight into the pockets of an investor. As a quick and dirty way of computing the cost of PFLT’s leverage, I divide interest expenses each year by the total liabilities at the end of that fiscal year.

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What stands out is that PFLT’s cost of liabilities in 2016-2018 was actually below the AAA corporate bond yield. This coincides with a brief period of relatively good underwriting. On the flip side, in 2019 – 2023, the liabilities cost more than the AAA corporate bond yield, coinciding with a period of quite bad loan losses. In general, PFLT’s liabilities cost somewhat more than those of the industry bellwether ARCC.

Diversification By Industry

The reason why we care about portfolio industry diversification is that we want BDCs to avoid investing in cyclical industries. For example, the years 2014 and 2015 were somewhat rough years for BDCs because of the overproduction of shale oil in the US that caused a decline in oil prices. BDCs with concentrations in oil & gas in their portfolios were hard hit during those years.

I have included below a chart taken from PFLT’s 2023 10-K filing that details the portfolio diversification as of Sept 30, 2023:

PFLT is very widely diversified across many industries, better so than most BDCs. Energy equipment and services occupies just 1% of the portfolio, and so PFLT’s exposure to cyclical industries is not a concern.

Conclusions

PFLT’s past has two defects which would disqualify it for long-term buy & hold investing, in my opinion.

• Balance sheet leverage has been inconsistent. Over the past 10 years, PFLT has veered from underleveraged, to overleveraged, and back to somewhat underleveraged. This shows that management’s hand on the steering rudder is not entirely steady.
• PFLT has not had a good track record of protecting net asset value via its underwriting. While it had a stretch of decent underwriting from 2014 – 2018, it significantly deteriorated in 2019 – 2023. Again, what troubles me is inconsistency.

While PFLT does yield just north of 10%, the extra 1-2% in dividend yield as compared with other BDCs does not, on my book, compensate for its spotty track record in the above two aspects. Therefore, I would rate PFLT as a sell.