S&P Lowers Outlook on Pennant Investment (PNNT) to Negative; Notes Exposure to Energy-Related Investments

Standard & Poor's Ratings Services said it revised its outlook on PennantPark Investment Corp. (Nasdaq: PNNT) to negative from stable. We also affirmed the 'BBB-' issuer credit rating on PNNT and 'BBB-' rating on the firm's senior unsecured notes.

"The outlook revision to negative reflects PNNT's high exposure to energy-related investments relative to most peers, which has come under pressure due to falling energy prices," said Standard & Poor's credit analyst Clayton Montgomery. It also reflects increased nonaccruals and unrealized losses, as well as a steadily worsening leverage profile.

Energy investments now account for 12% of PNNT's investments at fair value, down from 17% as of Sept. 30, 2014. While the firm has had success investing in the sector previously, the precipitous decline in energy prices has left PNNT overexposed to a weak and cyclical sector, in our view. Most of PNNT's energy-related investments have taken unrealized losses, and one investment (New Gulf Resources) is currently on nonaccrual. Furthermore, PNNT has had to restructure RAM Energy, its largest energy-related investment, converting one of its first-lien term loan positions to equity and amending its other first-lien term loan to be able to pay interest in kind rather than in cash going forward.

We believe the company's exposure to energy investments detracts from what we already viewed as a weak risk position relative to peers. PNNT's core strategy focuses on originating and managing second-lien and mezzanine investments versus many peers who have greater exposure to first-lien securities, which we view more favorably. Equities currently only make up 8% of the portfolio, but we believe this could increase as some of the firm's stressed investments have restructuring events.

We believe PNNT's portfolio company statistics and the weighted average yield on its debt investments reflect the firm's more aggressive risk profile versus many rated peers. As of Sept. 30, average leverage at the firm's portfolio companies was 5.0x, average cash interest coverage was 2.4x, and the firm's debt investments had an average yield of 12.4%. These levels are weak relative to many business development companies (BDCs) we rate. Additionally, nonaccruals increased meaningfully in the quarter ending Sept. 30 to 10.4% of loans at cost. The jump was due to the firm moving its investment in New Gulf Resources and Affinion Group to nonaccrual status, increasing total nonaccruals to four portfolio companies. PNNT is currently an outlier based on this measure when compared with rated peers, although this metric may decrease as the firm restructures positions.

Leverage (debt to adjusted total equity [ATE]) has steadily increased over the past several years while interest coverage has decreased. Leverage was 0.43x and non-deal-dependent coverage of interest expense was 5.1x as of Sept. 30, 2012. Those metrics have now deteriorated to 0.72x and 3.6x, respectively, as of Sept. 30, 2015. The firm is now operating above its target leverage range of 0.6x-0.8x (total debt to equity). We think that leverage will likely remain elevated relative to historical levels, at least in the near term. The company currently is trading well below its book value (0.74x as of Nov. 30), limiting its ability to raise equity, and the firm has a share buyback authorization outstanding ($17 million left as of Sept. 30), which we believe will help sustain higher leverage levels.

Despite increasing leverage, the firm still maintains an adequate cushion relative to required regulatory asset coverage levels. As of Sept. 30, PNNT's asset coverage ratio was 257%, down from 320% a year earlier. The company benefits from being able to exclude Small Business Administration debt from the calculation of this metric. PNNT has no debt maturities until 2019, and the firm's funding profile was about 53% unsecured (consisting of two bonds) as of Sept. 30, 2015, which we view favorably.

The negative outlook reflects the recent weakness in PNNT's portfolio and the firm's steadily increasing leverage. We now see at least a one-third probability that we could downgrade the company over the next 18-24 months. We could downgrade the firm if PNNT experiences further significant deterioration in its portfolio, its top five investments increase to above 50% of ATE, or if leverage increases to above 1x debt to ATE.

An upgrade is unlikely over the next two years because of the firm's focus on investments lower in the capital structure. We could revise the outlook to stable, however, if PNNT consistently maintains leverage below 1x debt to ATE and non-deal-dependent interest coverage above 3x, and investment performance and asset quality stabilize and begin to improve.

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