Description

Current Price: $11.99 / Dividend Yield: 9.51% / PF NAV: ~$14.42

Summary Thesis

If you are looking for a company at a cyclical inflection point that may double over the next year, this is not it. This is, however, a simple story with an attractive, equity-like upside and relatively low, bond-like downside. At the current share price, PFLT offers the prospect of earning ~25% absolute return over the next 12 months through a combination of: (1) an attractive dividend yield of +9.5%; and (2) narrowing the ~20% discount to NAV. The stock, which until recently traded in an approx. +/-5% band of NAV, has declined ~15% (vs ~5% for the peer group index) mainly due to technical selling and other non-fundamental factors, in my opinion, post its acquisition of MCG Capital (MCGC) which closed in Q3-2015. I believe there are three identifiable reasons why this opportunity exists: 

1. Merger arbs exiting: selling pressure by arbs and event-driven investors during and post-closing of the MCGC acquisition; this is a small cap situation so it doesn’t take much to move the stock;

2. Fundamental investors selling: for a short period of time, the company will under-earn its dividend as the asset base PFLT acquired from MCGC is largely cash; however, given the recent widening in credit spreads, PFLT now has significant ‘dry powder’ to put to work in dislocated situations at attractive yields; and   

3. Lack of interest from new investors: failure to recover after industry sell-off in August/September due to: (i) relatively small size, (ii) lack of major sell-side coverage and (iii) stock doesn’t screen well due to the temporary overhang of under-earning the dividend (#2); as a result BDC/yield-oriented investors have largely gravitated towards larger cap BDCs issued by the likes of Ares Capital and Blackrock Capital.

While waiting for the discount to narrow and the stock to revert back to its historical band, which I believe will occur as the company deploys its excess cash, investors can earn an attractive +9.5% dividend. It is worthwhile noting that insiders have been buying the stock post the recent decline.

The Business

PFLT is a business development company (BDC) that invests principally in senior secured debt securities of middle-market private corporations that may be too small to access the high yield market. PFLT went public in April 2011, raising $100MM in equity. Prior to the recent $167MM acquisition of MCGC, PFLT had an investment portfolio of $359MM with an average yield of 8.3%. This compares to a weighted cost of capital (based on Q2-2015 40% debt/60% equity mix) of 6.5%. The company is externally managed by PennantPark Investment Advisers, LLC which was founded by Art Penn, former co-founder and Managing Partner of Apollo Investment Management, LP (Apollo Management’s credit investing platform).

The Portfolio:

97% of the portfolio is floating rate (with a floor) and 85% of the portfolio is 1^st lien senior secured. In order to enhance the return profile, PFLT has selectively invested in the junior securities of companies it knows very well – 13% in 2^nd lien debt and 2% in sub debt/equity. The portfolio has exposure to 72 companies across 22 different sectors, with an average investment size of $5MM. The main industry concentrations include healthcare (12%), tech (12%) and business services (10%), with oil and gas (largely midstream assets) accounting for ~3%. The weighted average debt leverage (through PFLT’s position in the capital stack) and interest coverage ratios are 3.9x and 3.3x, respectively. The company has experienced only one default during its +4 year history but didn’t realize a loss – PFLT worked with the company to restructure its balance sheet and revive its business.

Over the last three years, PFLT investors have enjoyed a pretty steady ride with consistent monthly dividends (never reduced) and a narrow trade range to NAV. Recent events, specifically the MCGC transaction, changed that dynamic.

The MCGC Transaction

Initial Decision:

MCGC was written up as a long investment by ladera838 in November 2014 – worthwhile reading for background information. MCGC was a poorly managed BDC that incurred significant losses during its lifetime and struggled to grow as a result. At the behest of some vocal shareholders, management made the determination to discontinue operations, liquidate the portfolio and tender for the stock given the significant discount to NAV. In November 2014, MCGC offered to buy 53% of the then outstanding common stock at a price between $3.25 and $3.75 with prevailing (Q3-2014) NAV at ~$4.50/share (mostly cash with legacy positions in run-off). The tender expired in December and was materially undersubscribed (only ~11%). In February 2015, management announced the logical next step to evaluate options, including a sale of the company. MCGC hired Morgan Stanley which shopped the company to several potential bidders. By Q2-2015, MCGC had ~$175MM in net asset value or $4.75/share: $149MM in cash and $29MM in loan investments against $3MM in liabilities.  

In April, PFLT was announced as the winning bidder with a stock/cash deal. The consideration to MCGC was structured in a way to avoid any possible dilution (issuing shares below NAV) to PFLT shareholders:  MCGC shareholders were offered a total nominal consideration of $4.75/share made up as follows:

1. Stock component: $4.521/share in PFLT stock with the exchange offer computed based on the higher of PFLT’s share price (based on a 10 day VWAP) and it’s NAV; and

2. Cash component: $0.226/share in cash to be paid by PFLT’s external manager not PFLT; in addition, to the extent that PFLT’s VWAP was less than it’s NAV, the external manager would pay MCGC a ‘true-up’ of up to an additional $0.08/share.

Enter the Arbs:

HC2 Holdings publicly disclosed its interest in MCGC and made a series of unsolicited bids, each higher than the prior, above the $4.75/share level using its arguably inflated stock as currency (no cash consideration). The arbs entered, as did some ‘activists’, writing letters to the MCGC Board to seriously evaluate the HC2 offer.  After much diligence, the Board concluded that the HC2 proposal was inferior and publicly disclosed multiple investor presentations highlighting several potential reasons for the apparent extreme overvaluation of HC2 stock. The reality was that HC2 wanted to raise cash (to deleverage its balance sheet) and the MCGC acquisition was an attractive alternative to a secondary (as a side note, HC2’s stock has declined ~30% since their bid was disclosed).  When it became clear the PFLT’s offer would prevail, arbs started to exit and continued to do so post-closing when they had more liquidity.

At Closing:

On August 17, we know that:

• MCGC’s NAV was ~$4.75/sh

• PFLT’s NAV was ~$14.11/sh and its 10 day VWAP was $13.27, so the share consideration was based on PFLT’s NAV

• MCGC shareholders were paid 0.32044 shares of PFLT based on NAV: $14.11 x 0.32044 = $4.52 in NAV from PFLT

Therefore, PFLT got $4.75/sh in MCGC’s NAV and only gave up $4.52/sh in NAV – on 37MM MCGC shares, that equates to $8.5MM in NAV accretion, pre-deal fees. Clearly a good deal for PFLT – not only was the transaction marginally accretive, PFLT was able to nearly double its equity base without doing a dilutive secondary….a potentially game changing transaction!

PFLT-MCGC Combination

Using Q2’s numbers, this is what the pro forma balance sheet looks like:

PFLT’s NAV is disclosed on a quarterly basis and the Q2 NAV was $14.33/sh. However, based on the exchange ratio and cash consideration paid to MCGC shareholders, we can infer an approximate ‘mid-quarter’ NAV. Essentially, we know that the final exchange ratio was 0.32044 shares and that the final cash proceeds were $0.30595/sh. Using the exchange offer math, the NAV needed to arrive at a 0.32044 exchange ratio is $14.1085/sh ($4.521/0.32044=$14.1085). The difference between the two NAV numbers ($14.33 and $14.11) is $3.2MM, which approximates my estimate of 2% deal fees for the transaction. As there was no mention of crystalized credit losses or an increase in loan loss reserves on the closing date, my working assumption is that deal fees accounts for the difference.

Summary

My estimate of PF NAV is ~$14.42/sh or ~20% above the current stock price. If we conservatively assume that mid-quarter decline in NAV is loan-book related and deal expense is an additional hit to equity value, then NAV drops to $14.30/sh, still significantly higher than the current stock price. In addition, PFLT pays a monthly dividend of $0.095/sh ($1.14/year) or 9.5% annual yield.

Risks

• Line item transparency – as with all BDCs/lending institutions, it is tough to get line item visibility to determine the quality of the loan book. What we do know is that the majority of their loan book is senior secured (1^st in line); they have di minimus exposure to midstream oil and gas; and they have had only one default in their +4 year history (admittedly during a low default rate period) and didn’t skip/alter the dividend.

• Interest rate risk – PFLT’s loans are floating with a floor.

Catalyst

• Continued strong execution
• Deployment of excess cash at attractive yields
• NAV growth
• More insider buying if discount to NAV persists
• Sellside coverage from larger institutions