Prospect Capital Corporation (PSEC) Q4 2016 Earnings Report, Transcript and Summary

Good morning and welcome to the Prospect Capital Fourth Quarter and Fiscal year Earnings Release and Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note that this event is being recorded. I would now like to turn the conference over to Mr. John Barry, Chairman and CEO. Please go ahead, sir.

Thank you, Dan. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Brian Oswald, our Chief Financial Officer. Brian?

Thanks, John. This call is the property of Prospect Capital Corporation. Unauthorized use is prohibited. This call contains forward-looking statements within the meaning of the securities laws that are intended to be subject to Safe Harbor protection. Actual outcomes and results could differ materially from those forecasts due to the impact of many factors. We do not undertake to update our forward-looking statements unless required by law. For additional disclosure, see our earnings press release, our 10-K, and our corporate presentation filed previously and available on the Investor Relations tab on our website, prospectstreet.com. Now, I’ll turn the call back over to John.

Thank you, Brian. For the June 2016 fiscal year, our net investment income or NII was $371.1 million, or $1.04 per share, $0.04 more than our dividends. Our distributable income was $379.9 million, or $1.07 per share, $0.07 more than our dividends. Our NII in the March 2016 quarter was $91.4 million, or 26% – $0.26 per share, $0.01 more than our dividends. Our distributable income was $96.6 million, or $0.26 per share, $0.02 more than our dividends. We have previously announced monthly cash dividends to shareholders of $0.08333 per share for September and October 2016, with the latter representing our 99th consecutive shareholder distribution in our company’s history. We plan on announcing our next series of shareholder distributions in November. We have generated cumulative distributable income in excess of cumulative dividends to shareholders since Prospect’s IPO 12 years ago. Since our IPO 12 years ago through October – through our October 2016 distribution at the current share count, we will have paid out $15.12 per share to initial continuing shareholders, exceeding $2 billion in cumulative distributions to all shareholders. We have delivered solid returns, while keeping leverage prudent. Net of cash and equivalents, our debt to equity ratio was 69.5% in June 2016, down 810 basis points from 77.6% in June 2015. Our NAV stood at $9.62 per share in June 2016, up $0.01 from the prior quarter. Our balance sheet as of June 30, 2016 consisted of 91% floating rate interest earning assets and 99% fixed rate liabilities, positioning us to benefit from potentially significant increases in short-term interest rates. During the June 2016 quarter, we exited Harbortouch payments for $328 million, including fees and escrowed amounts, for an expected IRR on all of our capital, up 14%. We believe, there’s no greater alignment between management and shareholders than for management to own a significant amount of stock, particularly when such stock is purchased on the open market. As with Prospect, management is the largest shareholder in Prospect and has never sold a single share. Management on a combined basis has purchased that cost over $160 million of stock in Prospect, including over $100 million since December 2015. Our objective is to drive future earnings through prudent levels of matched-book funding. We are currently exploring initiatives to enhance our funding liability ladder, opportunistically harvest certain controlled investments at a gain, optimize our origination strategy, repurchase shares at a discount to net asset value, and rotate our portfolio out of lower yielding assets into higher yielding assets, while maintaining a significant focus on first lien senior secured lending. Thank you. I’ll now turn the call over to Grier.

Thanks, John. Our skilled business with over $7 billion of assets and undrawn credit continues to deliver solid performance. Our team consists of approximately 100 professionals, representing one of the largest dedicated middle-market credit group in the industry. With our scale, longevity, experience, and deep bench, we continue to focus on a diversified investment strategy that covers third-party private equity sponsor-related and direct non-sponsor lending, Prospect sponsored operating and financial buyouts, structured credit, real estate yield investing, and online lending. As of June 2016, our controlled investments at fair value stood at 30% of our portfolio. This diversity allows us to source a broad range and high volume of opportunities, then select in a disciplined bottoms-up manner, the opportunities we deem to be the most attractive on a risk adjusted basis. Our team typically evaluates thousands of opportunities annually and invests in a disciplined manner in a low single-digit percentage of such opportunities. Prospect’s originations in recent months have been well diversified across our multiple origination strategies. Our non-bank structure gives us the flexibility to invest in multiple levels of the corporate capital stack, with a preference for secured lending and senior loans. As of June 2016, our portfolio at fair value comprised 50.0% first lien, 20.6% second lien, 17.1% structured credit with underlying first lien assets, 0.2% small business whole loan, 1.2% unsecured debt, and 10.9% equity investments, resulting in 88% of our investments being assets with underlying secured debt benefiting from borrower pledged collateral. Prospect’s approach is one that generates attractive risk adjusted yields, and our debt investments were generating an annualized yield of 13.2% as of June 2016, an increase of 50 basis points over June 2015. We also hold equity positions in many transactions that can act as yield enhancers or capital gains contributors as such positions generate distribution. We have continued to prioritize first lien, senior, and secured debt with our originations to protect against downside risk, while still achieving above market yields through credit selection discipline and a differentiated origination approach. As of June 2016, we held 125 portfolio companies, with a fair value of $5.9 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration, the largest is 8.2%. As of March 2016, our asset concentration in the energy industry stood at 2.9%, including our first lien senior secured loans, where third parties bear first loss capital risk. Our credit quality continues to be solid. Non-accruals as a percentage of total assets stood at approximately 1.4% in June 2016, with approximately 0.5% residing in the energy industry. Our weighted average portfolio net leverage stood at 4.18 times EBITDA. Our weighted average EBITDA per portfolio company stood at $48.1 million in June 2016. The majority of our portfolio consists of sole agented and self-originated middle-market loans. In recent years, we have received the risk adjusted reward to be superior for agented, self-originated, and anchor investor opportunities, compared to the broadly syndicated market, causing us to prioritize our proactive sourcing efforts. Our differentiated call center initiative continues to drive proprietary deal flow for our business. Originations in the June 2016 quarter aggregated $294 million. We also experienced $384 million of repayments and exits as a validation of our capital preservation objective, resulting in net investment exits of $90 million. We slowed originations in the first-half of calendar 2016, due to market volatility, but expect to increase our investment pace depending on market conditions in the coming quarters. During the June 2016 quarter, our originations comprised 50% third-party sponsor deals, 25% online lending, 24% syndicated debt, and 1% real estate. Our financial services controlled investments are performing well with annualized cash yields ranging from 15% to 25%. Because of declining unemployment rates and declining commodity prices compared to prior years, we believe the outlook for consumer credit continues to be positive for 2016, boding well for such companies. To-date, we’ve made multiple investments in the real estate arena through our private REITs, largely focused on multifamily stabilized yield acquisitions with attractive 10-year financing. In the June 2016 quarter, we consolidated our REITs into NPRC. Our real estate portfolio is benefiting from rising rents and strong occupancies, and our cash yields have increased with each passing quarter. In the past few months, we have recapitalized many of our properties with attractive financing, so we can redeploy capital into other return enhancing avenues. Over the past few years, we’ve grown our online lending portfolio directly, as well as within NPRC, with a focus on super prime, prime, and near prime consumer and small business borrowers. This portfolio stands at approximately $806 million today, including third-party financing, across multiple origination and underwriting platforms. Our online business, which includes attractive advance rate financing for certain assets is currently delivering a mid-teens levered yield net of all costs and expected losses. In the past two years, we have closed and upsized five bank credit facilities and one securitization to support our online business, with more credit facilities and securitizations expected in the future. Our structured credit business performance has exceeded our underwriting expectations, demonstrating the benefits of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance, and focusing on attractive risk adjusted opportunities. As of June 2016, we held $1.0 billion across 38 non-recourse structured credit investments. Our underlying structured credit portfolio consisted of over 3,000 loans and a total asset base of over $18.5 billion. As of June 2016, our structured credit portfolio experienced a trailing 12-month default rate of 1.37%, or 60 basis points less than the broadly syndicated market default rate of 1.97%. In the June 2016 quarter, this portfolio generated an annualized cash yield of 22.8% and a GAAP yield of 15.4%. As of March 2016, our existing structured credit portfolio has generated $696 million in cumulative cash distributions, representing 54% of our original investment. We’ve also exited seven investments, totaling $154 million, with an average realized IRR of 16.8% and a cash on cash multiple of 1.42 times. Our structured credit portfolio consists entirely of majority owned positions. Such positions can enjoy significant benefits compared to minority holdings in the same tranche. In many cases, we received fee rebates in average of a 12% discount to the industry average because of our majority position. As a majority holder, we control the ability to call a transaction in our sole discretion in the future. And we believe, such options add substantial value to our portfolio. We have the option of waiting years to call a transaction in an optimal fashion rather than when loan asset valuations might be temporarily low. We as majority investor can refinance liabilities on more advantageous terms, as we have done four times since the beginning of 2015, and remove bond baskets in exchange for better terms from debt investors in the deal, as we have done five times since the beginning of 2015. Our structured credit equity portfolio has paid us an average 28.8% cash yield in the 12 months ended June 30, 2016. As the yield enhancement for our business, in the past two years, we launched an initiative to divest lower yielding loans from our balance sheet, thereby allowing us to rotate into higher yielding assets and to expand our ability to close scale, one-stop investment opportunities with efficient pricing. In fiscal 2016, we made five sales of such lower yielding investments, totaling $99.4 million, with a weighted average coupon of 6.1%. We receive recurring servicing fees paid by multiple loan purchasers in conjunction with these divested loans. We expect similar sales in the future as a potential earnings contributor for the June 2017 fiscal year and beyond. We have booked $174 million in originations and received exits of $51 million, resulting in net investments of $123 million so far in the current September 2016 quarter. Thank you. I’ll now turn the call over to Brian.

Thanks, Grier. We believe our prudent leverage, diversified access to matched-book funding, substantial majority of unencumbered assets, and weighting towards unsecured fixed rate debt demonstrate both balance sheet strength as well as substantial liquidity to capitalize on attractive opportunities. Our company has locked in the ladder of fixed rate liabilities extending nearly 30 years into the future, while the significant majority of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise. We’re a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, develop a notes program, issue an institutional bond, acquire another BDC and many other lists of firsts. Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry, which we have taken toward construction of the right-hand side of our balance sheet. As of June 2016, we held approximately $4.9 billion of our assets as unencumbered assets, representing 78% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, which has a AA rated $885 million revolver with 22 banks and with $1.5 billion total size accordion feature at our option. The revolver is priced at LIBOR plus 225 basis points and revolves until March 2019, followed by one year of amortization with interest distributions continuing to be allowed to us. Outside of our revolver and benefiting from our unencumbered assets, we’ve issued at Prospect Capital Corporation multiple types of investment grade unsecured debt, including convertible bonds, institutional bonds, baby bonds, and program notes. All of these types of unsecured debt have no financial covenants, no asset restrictions, and no cross defaults with our revolver. We enjoy an investment grade rating BBB+ from Kroll and an investment grade BBB- rating from S&P. We’ve now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration up to nearly 30 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we’ve substantially reduced our counterparty risk over the years. We have refinanced three debt maturities in the past year, including our $100 million baby bond in May 2015, our $150 million convertible note in December 2015, and our $167.5 million convertible note in August 2016. We have no significant liability maturities exceeding $10 million in fiscal year 2017. Our $885 million revolver is currently undrawn. If the need should arise to decrease our leverage ratio, we believe we can slow originations and allow repayments and exits to come in during the ordinary course as we demonstrated in the first-half of calendar year 2016. In fiscal year 2016, we enjoyed $1.3 billion of repayments, which we view as a validation of our strong underwriting and credit processes. On December 10, 2015, we issued $160 million, 6.25% senior unsecured notes that are due in June 2024. We’ve increased that baby bond since – by $39 million under an ATM program from June to August 2016. As of June 30, 2016, we had 909 million of Program Notes outstanding with staggered maturities between October 2016 and October 2043 and a weighted average interest rate of 5.2%. On July 28, 2015, we began repurchasing our shares of common stock as they were trading at a discount to NAV. Since that time, we have purchased 4.71 million shares of common stock at an average price of $7.27 per share. Repurchases total approximately $34 million to-date. As of June 2016, 100% of Prospect’s assets across its portfolio are Level 3 assets under ASC 820, meaning, such assets are illiquid with unobservable inputs and with a requirement to use estimation techniques. When Prospect went public in 2004, Prospect’s Board of Directors instituted best practice in the BDC industry by employing third-party valuation firms to value 100% of the company’s Level 3 assets for each fiscal quarter using positive assurance methodology. Prior to Prospect’s leading by example, other companies in the industry used self-valuations, sampling, and other less robust methods for Level 3 portfolio valuation. In determining the fair value of portfolio investments, the Audit Committee and the Board of Directors of the company, including our independent directors, primarily evaluate the range of valuations from three independent valuation firms. For our structured credit investments, the independent valuation firm primarily uses a single cash flow approach based on our expected cash flows. In order to validate the results from the single cash flow methodology, the valuation agent also utilizes a multi-path pawn Monte Carlo simulation approach along with reviewing changes in market conditions for similarly trading securities. The Board of Directors looks at several factors in determining where within the range to value each Prospect asset, including recent operating and financial trends for the asset, independent ratings obtained from third parties, comparable multiples for recent sales of companies within the industry, and discounted cash flow models. Final selected valuations have never been outside the range provided by the third-party valuation firms. We currently have no money drawn under our revolver. Assuming sufficient assets are pledged to the revolver and that we are in compliance with all revolver terms, we have $642 million of new facility-based investment capacity, not including cash at the Prospect level. We recently completed an amendment of our Facility to enhance the eligibility of loan asset collateral that we can pledge to the Facility. Now, I’ll turn the call back over to John.

Thank you very much, Brian. We can now answer any questions.

Ladies and gentlemen, we will now begin the question-and-answer session. [Operator Instructions] And our first question comes from Christopher Testa of National Securities Corp. Please go ahead.

Hey, good morning, guys. Thank you for taking my questions. Just with the CLO cash yields being down on the quarter, just wondering if you could say how much of that was due to LIBOR increases, and how much was due to less reinvestment opportunities, given the loan price rally?

Christopher, I’d like to suggest that Grier take that question. Go ahead, Grier.

Thanks for your question, Chris. I’d say, you had one of the two primary drivers in there, which was the change in LIBOR, because the Fed move occurred in December and then the way the loan pricing reset occurred, a lot of that doesn’t hit until more like the April timeframe. Second driver is less in reinvestment opportunities. I wouldn’t describe it as that, but more just an expectation of increased defaults, given where we are in the cycle. And you’ve seen a – an increase in defaults in the broader syndicated loan market and in our book. Although, as we pointed out, we’ve substantially outperformed the broader market. So it’s really those two factors. I don’t think we have at our fingertips the exact decoupling of how much room from each one.

Okay. And were those factors also similar for the – reason for the GAAP level yield going down as well?

Yes. Sorry, that’s what I was – that’s what I thought I was addressing, yes.

Yes, I just meant the cash yields, but…

Oh, on a cash basis, I would say, it’s those two factors, again, it’s the LIBOR change as well as an increase in defaults, yes, both factors are the answer for both cash, as well as GAAP.

Got it. And with spreads back down, do you have an idea of how much was CLO book has potential to refi the debt holders?

When you say refi the debt holders…

Yes, I’d say deals…

…our refinancing deals, whereas the majority holder we have the right to go out and obtain new financing? Is that, what you mean?

Yes, correct.

Okay. I would say that AAA spreads have been – people use the phrase stubbornly wide for a while, maybe they just got too used to really tight spreads in the last cycle. But they have started to come down modestly. What we’re exploring at this stage more so than simply refinancing an existing deal, Chris, is extending our current deals, because we want to try to push deals out in tenor as long as it’s prudently and economically possible. That way you’re sort of pole vaulting past, the next recession, nobody knows with precision, of course, when exactly that’s going to occur 2018, 2019, 2020, and no one one really knows exactly. But what you do want is to have your deals open to buy when that occurs, because those are wonderful opportunities to use your deals to acquire assets at attractive prices as opposed to getting near the end of their economic life. So we’re very focused on that. There is a risk retention date coming in December and extending deals prior to then – prior to risk retention requirements is an important priority in the book. It doesn’t mean the world ends after risk retention kicks in, it just means that you’ll need to have some different players in the capital structure and it will be a little bit trickier to do it then.

That’s a good color. Thank you. And just previously where you guys had mentioned strength of the consumer and the consumer being in good shape, a lot of the online lenders, consumer lenders have seen provisioning go up charge-offs increase. Just wondering if the results from online and consumer lenders have changed their view on this space at all?

It’s interesting, Chris, the publicly reporting players in this – in the sector report for the most part loans that are not the loans that we’re actually buying. They report – part of our book is prime-based loans and part of our book is near-prime loans on the consumer side of things, at least, we also have a separate smaller SME book. But when folk – people need to be careful when they see reports of provisioning and credit, because generally speaking that’s referring to different assets. With our book, three quarters of it is near-prime assets with lending clubs, and we are quite pleased with the performance of that book. Our credit has stayed pretty much within underwriting assumptions and strategies works very well for us. We’re probably a tad under-levered in that business right now. And what we’re focused on doing is exploring the securitization markets that had understandably retreated like so many other securitization markets when volatility kicked in around the beginning of the year. There was a securitization in the space just a few weeks ago, and we’re actively exploring our own securitizations that enhance our return on equity, return on capital to us, and allow us to reinvest in other income-producing properties. But we’re also actively exploring other platforms, both on the SME side, as well as on the consumer side. I think our team has explored maybe three dozen different platform potential relationships, some of which we would be a loan buyer too, some of which we would be an acquirer of the origination platform and a loan buyer, so hybrid model. So we continue to explore a lot of different possibilities in this emerging and well-performing space. And I don’t think, you’ll see us dependent upon any one relationship or any one platform for capital deployment.

Okay, great. And last one from me, just wondering if you could provide us with a clarification on your loan rotation strategies. So you had mentioned selling loans with 6.1% average coupons. So as you rotate into higher yielding loans, what should we expect to different structure of those higher yielding loans to be in terms of leverage average EBITDA, et cetera. Could you just give us some detail on that?

Sure. Well, in general, these types of Term Loan A lower yielding assets, which we typically purchase as part of our one-stop strategy, we do unit tranches from time-to-time, but a lot of times we buy first lien debt, self-originated, self-agented debt, where we bifurcate into a first lien Term Loan A and a first lien Term Loan B. That Term Loan A tends to be in the lower yielding side. And we’ve been very selectively selling our assets to – I’ll describe it as more passive upstream players and less active origination competitors. So less selling to other BDCs or private debt direct lenders and more upstream insurance companies, pension plans, those types of players. So we’re very careful and choosey as to who we want to sell those assets to. The team is working very actively on some interesting strategic relationships, where we could sell those assets in, not only a greater volume from the existing book, but also have folks on a recurring and ongoing basis available to buy those assets at the time of origination. In terms of what returns we would get in redeploying those six circa coupon deals into really its diversified array of strategies, our weighted average coupon is 13%-ish range. So it’s hard to say with precision what the coupon or EBITDA would be. As we pointed out, we’re very careful about leverage at the portfolio level. Our weighted average borrower is levered at only 4.2 turns of EBITDA, well over a turn below some of our BDC rather in – and I think, you see that show up positively in our underwriting results.

Right. That’s all from me. Thanks for taking my questions.

Thanks, Chris.

Thank you.

And our next question comes from Gil Marchand of the Knights of Columbus. Please go ahead.

Can you guys just touch on the institutional bond market and if you think that market is open?

Hi, Gil, let me start with that, and we’ll see if Brian wants to add to that. Well, the institutional bond market I would kind of separate for our company and sector into straight bond market, as well as the convertible bond market. And we’ve been and there has been somewhat muted issuance as you probably know in the space during the course of calendar year 2016. But our observation is, that is changing in real-time, and we’re seeing much greater access to those markets heading into the fall compared to just a few months ago. Our belief as an accesser of the fixed income markets is to have a diversified and balanced approach, where we’re not dependent upon any one particular market. So we’ve tapped the institutional bond market multiple times, the convert markets that we pioneered at a company multiple times. We’re the only company in our space, I believe that accesses weekly retail program notes. That’s a very intense logistically and otherwise intense effort, but worth it because of the access it provides us. And then the baby bond retail side of things, where we also recently instituted an ATM. So that’s several different, at least, a handful of different options for us, and we like having that balance to maintain a competitive tension and how we’re accessing different capital make sure that we’re – we continue in a prudent way to push out our maturities. And we have no material maturities at all now having paid off a recent convert in the current 2017 fiscal year. And, of course, we have our bank revolver of – with 22 banks, where we recently expanded our borrowing base and got more flexibility from the bank group. So, but the institutional bond market is very important to us, Gil. And you’ll see us continue to have a strong dialogue with our current base of fixed income investors and as well as new prospective investors. Brian, anything you would add to that.

Nope.

Sure. Then also you mentioned the energy non-accruals, I think you said as of March, is there a reason you used March instead of June?

Oh, apologies, I must have misspoken. I meant to say June. We did have a slight uptick in non-accruals in the quarter largely from one particular deal USES, which I think will matter. We’ve never labeled energy, but considering it sells to energy companies, one can argue that it’s caught up in the whole energy cyclical aspect it’s obviously been the number one credit impact story in the last 18 months. We’re pleased that outside of those energy and related deals, our non-accrual rate is something like 29 basis points. So we think strong credit selection has shown through to our business results.

Okay, thanks. And then just two more, your leverage declined in the June quarter, any comments on if you see that’s staying flat, or do you assume it’s going to go up to your prior level?

Well, we’re at the lower range, Gil, of the sort of 0.7 to 0.8 net leverage zone. I think, we’ve got a slide on that in our corporate presentation that shows where that’s been with each passing quarter. So we’re on the lower end, because we sold Harbortouch as a meaningful exit and a nice performing exit for us. So we’ll be deploying capital in new originations and bringing that higher up within the target zone is our expectation. Of course, you could always get a repayment that kicks in that that slows that. As you know, originations aren’t an exit to that matter, not always on a perfect conveyor belt. Brian, you want to add to that?

Yes, I think one of the things that that’s important to point out there too is that, the sale of Harbortouch also reduced our interest income for the last month of the quarter. And as we redeploy that, those funds, we will regenerate some of the interest income that was lost from that repayment. So, yes, it’s our intention to continue to redeploy that capital and use a portion of our credit facility to increase returns

Okay, thanks. And then lastly, in structured products, just two short questions. One, I think you said you sold a few investments, I’m wondering how that compared to the mark, I know they had a good IRR, congratulations. And then secondly, we really don’t care, but on the equity side, some of your market followers tend not to like that asset class, and I see you bought a couple CLOs in the quarter, just if you could comment on that? Thanks.

Well, I just had spoken to Grier.

Sure. So we did sell some assets in the March quarter that were above our marks. So you can refer to our 10-Q that we filed in May, pertained to the March quarter for more information on that. And then as it pertains to deploying capital in new opportunities, we have in this – in the structured credit book, which realizes only about 17% of our assets, sometimes people, I’m not going to say, you’ve forgotten that, but sometimes people do forget that. In the structured credit book, it does get reduced through an amortization of our cost basis with each passing quarter. So we are interested in finding attractive deals, not on a no matter what basis, but where we see good opportunities in the market. And we’ve seen some recently in the primary side and have to – did one add-on and then invested in a new deal as well. And I think you’ll see us opportunistically continue to look at that market, balancing the time demands of those originations versus the extension of strategy that I mentioned earlier. That doesn’t necessarily add to our invested capital, but we think continues to de-risk the book by pushing those deals back longer in tenor to be able to withstand market cycles even better.

Thanks;

Thank you, Gil.

And ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to John Barry for any closing remarks.

Well, thank you, everyone, and have a wonderful afternoon. Bye now.

Thank you.