Prospect Capital Corporation (PSEC) Q1 2017 Earnings Report, Transcript and Summary

Good day and welcome to the Prospect Capital Corporation's First Fiscal Quarter Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to John Barry, Chairman and CEO. Please go ahead.

Thank you, Nicole. 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 forecast 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 press release, our 10-Q, and our corporate presentation filed previously and available on the Investor Relations tab on our Web-site, prospectstreet.com. Now, I'll turn the call back over to John.

Thank you, Brian. For the September 2016 fiscal quarter, our net investment income or NII was $78.9 million, $0.22 per share, equalling our distributable income. Our net income was $81.4 million, $0.23 per share. Earnings declined from the prior quarter primarily because of a decrease in interest and other income from the sale of Harbortouch. We used $0.03 of our $0.30 per share of Spillback income to support our $0.25 per share in shareholder distributions paid last quarter. We still have $0.27 per share or $96.6 million of Spillback income to support future dividends, if needed. With the Harbortouch sale and other significant repayments, we were underinvested during the September quarter, carrying an average cash balance of $161 million and an average revolver draw of $2 million. If another $460 million of 10% annualized coupon earning assets had been on our books, utilizing our uninvested cash and financing the remainder from our revolver during the September quarter, net income would have been $7 million higher, without accounting for any additional structuring fee or prepayment income that may have been generated in connection with such originations. We are focused on achieving full investment with prudent originations meeting not only strict diligence standards but also return and capital preservation requirement. We previously announced monthly cash dividends to shareholders of $0.08333 per share for November, December and January, the last being the 102nd consecutive shareholder distribution in our Company's history. We will announce our next series of shareholder distributions in February. Since our IPO 12 years ago through our January distribution at the current share count, we will have paid out $15.37 per share to initial continuing shareholders, exceeding $2.1 billion in cumulative distributions to all shareholders. Our NAV was $9.60 per share in September, down $0.02 from the prior quarter. Our debt-to-equity ratio was 76.3%, down 170 basis points from 78% in September 2015. Our assets as of September 30 comprised 90% floating rate assets and 98% fixed rate liabilities, positioning us to benefit from rising interest rates. Thank you. I'll now turn the call over to Grier.

Thanks John. Our scaled 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 groups 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 September 2016, our controlled investments at fair value stood at 31% 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. 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 September 2016, our portfolio at fair value comprised 51.5% first lien, 19.5% second lien, 16.9% structured credit with underlying first lien assets, 0.2% small business whole loan, 1.1% unsecured debt and 10.8% 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 12.8% as of September 2016. We also hold equity positions in many transactions that can act as yield enhancers or capital gains contributors as such positions generate distributions. 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 September 2016, we held 123 portfolio companies with a fair value of $6.11 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 9.3%. As of September 2016, our asset concentration in the energy industry stood at 2.6%, 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 1.6% in September 2016, with approximately 0.5% residing in the energy industry. Our weighted average portfolio net leverage stood at 4.07x EBITDA, down from 4.18x in June 2016 and down from 4.36x in September 2015. Our weighted average EBITDA per portfolio company stood at $51.7 million in September 2016, up from $48.1 million in June and up from $44.6 million in September 2015. The majority of our portfolio consists of sole agented and self-originated middle-market loans. In recent years, we have perceived the risk adjusted reward to be higher 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 September 2016 quarter aggregated $347 million. We also experienced $114 million of repayments and exits as a validation of our capital preservation objective, resulting in net originations of $233 million. During the September 2016 quarter, our originations comprised 36% third-party sponsor deals, 20% online lending, 20% structured credit, 14% real estate, 6% syndicated debt and 4% operating buyouts. Our financial services controlled investments are performing well with annualized cash yields ranging from 15% to 25%. Because of lower unemployment rates and commodity prices compared to years ago, we believe the outlook for consumer credit continues to be positive for 2016 and 2017. 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 tenure 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 NPRC properties with attractive financing and exited completely certain properties including Vista and Abbington, so we can redeploy capital into other return-enhancing avenues. We expect both recapitalizations and exits to continue. We also recently closed our first portfolio investment in student housing, an attractive segment similar to multifamily residential where we have analyzed many opportunities for several years. 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 $577 million today of loans and securitization interests, 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 few years, we've closed and up-sized five bank credit facilities and two securitizations, including recently our first consumer 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 September 2016, we held $1.0 billion across 40 non-recourse structured credit investments. Our underlying structured credit portfolio consisted of over 2,900 loans and a total asset base of over $19.6 billion. As of September 2016, our structured credit portfolio experienced a trailing 12-month default rate of 1.39% or 56 basis points less than the broadly syndicated market default rate of 1.95%. In the September 2016 quarter, this portfolio generated an annualized cash yield of 26.1% and a GAAP yield of 16.1%. As of September 2016, our existing structured credit portfolio has generated $759 million in cumulative cash distributions, representing 58% of our original investment. We have also exited seven investments totaling $154 million, with an average realized IRR of 16.8% and cash on cash multiple of 1.42x. 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 and average of a 14% discounted 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've done six times since the beginning of 2015, with more possible. We move bond baskets in exchange for better terms from debt investors in the deal, as we've done five times since the beginning of 2015, with more possible. And extend or reset the investment period to enhance value, as we've done three times so far in calendar 2016, with more possible. Our structured credit equity portfolio has paid us an average 26.5% cash yield in the 12 months ended September 30, 2016. We've booked $135 million in originations and received exits of $378 million, resulting in net exits of $243 million so far in the current December 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 fundings, 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 a 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 September 2016, we held approximately $4.8 billion of our assets as unencumbered assets, representing approximately 76% of our portfolio. The remaining assets are pledged to Prospect Capital Funding LLC, which has a AA rated $885 million revolver with 21 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 have 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 BBB+ rating from Kroll and investment grade BBB- rating from S&P, each recently reaffirmed. We've now tapped the unsecured 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 have substantially reduced our counterparty risk over the years. We have refinanced three debt maturities in the past year and a half, including our $100 million baby bond in May 2015, our $115 million convertible note in December 2015 and our $167.5 million convertible note in August 2016. We have no liability maturities exceeding $10 million in the fiscal year 2017. Our $885 million revolver is currently undrawn. If the need should arise to decrease our leverage ratio, we believe we could 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. During the September 2016 quarter, we received $114 million of repayments, which we view as a validation of our strong underwriting and credit processes. On December 10, 2015, we issued $160 million of 6.25% senior secured notes due June 2024. We have increased that bond by $39 million under an ATM program from June to August 2016. We now have seven separate unsecured debt issuances aggregating $1.67 billion, not including our notes program with maturities ranging from October 2017 to June 2024. As of September 30, 2016, we had $946 million of program notes outstanding with staggered maturities through October 2043 and the weighted average interest rate of 5.2%. On July 28, 2015, we began repurchasing our shares of common stock as they have been trading at a discount to NAV. Since that time, we have repurchased 4.71 million shares of common stock at an average price of $7.27 per share. Repurchases total approximately $34 million to date. 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 $640 million of new facility-based investment capacity, not including cash at the Prospect level. In the September 2016 quarter, we completed amendment to our credit 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.

Thanks Brian. We can now answer any questions.

[Operator Instructions] Our first question comes from Christopher Nolan of FBR & Co. Please go ahead.

Online loans seem to have declined since the last quarter, if I understand correctly. What's [indiscernible]?

Sure. They haven't actually declined in terms of our invested capital. What's happened is, we securitized our near prime consumer portfolio. So, the number that I quoted doesn't include the financing of that securitization. We've actually increased our online book a bit versus the prior quarter.

Got you. Thank you. And also in your comments for the real estate, it sounds like you guys are shying away from multifamily and looking at student. What are the yields that you should see on student investments versus multifamily?

Sure. We're actually not shying away from multifamily. What we're doing is we are harvesting assets after we have executed on a substantial amount of our renovation upgrade program. Our strategy is to buy Class B, or in some cases Class C properties, and upgrade them with rent expansion and then to sell to another owner at an attractive price. It's a good time to sell assets given where cap rates are and given the plentiful availability of financing and the deep buyer base out there. So you have seen us monetize assets and expect to see us do that in the future as well, but at the same time we continue to deploy capital in new deals as well. It's more challenging to put capital to work really in a lot of parts of the private market, not just real estate but our core plurality corporate lending business as well because there's lot more capital out there than a couple of years ago, but we pick our spots and having a large team is very helpful. As it pertains to student housing, there are a lot of similarities with multifamily. There's a high premium on management team executional talent when you're talking about turning around virtually your entire tenant base in a couple of months' period, so certain nuances of that that are highly management team specific. But we expect similar yields in that segment and similar returns as what we've got in multifamily. So, we'll see. I'm not sure how much we'll do there. It's all on a bottoms-up basis, deal by deal, in the real estate book, just like the rest of our origination process, Chris.

And then final question, given the surprising election result, do you guys have any thoughts in terms of the potential impact on the BDC sector in general and Prospect in particular?

Sure. I think it's pretty soon, it's extremely soon and somewhat speculative at this stage to talk about the impact. I mean there are so many aspects where the government interrelates with business and our lives, right from regulation to drivers of the economy, et cetera. So, we would not deem ourselves to have some view beyond speculation at this point versus a lot of pundits out there, many of which were obviously not always correct in their projection.

Okay. Thanks for taking my questions.

Our next question comes from Christopher Testa of National Securities Corporation. Please go ahead.

Just touching more on the multifamily, just wondering if you could discuss just the differential in cap rates between what you are able to sell, the Class B and Class C is at, and what you are investing into?

Sure. It's less of a significant delta in cap rates and more just boosting net operating income at the individual property level. Stabilized yield cap rates in kind of non-gateway cities for Class B properties were generally in the 6% to 7% range out there, give or take, plus or minus. We obviously are trying to buy to the maximum extent possible off-market properties, properties where we think we have an edge in conjunction with our co-investing management team partners that put up capital alongside us in each deal. But it's more of an NOI expansion generally through rent increases and a rehabilitation program.

Got it. And just with the CLO equity, so the cash yields were up nicely quarter-over-quarter, the loan market volatility is obviously subsided which hinders kind of reinvestment opportunity. So, was the cash yields equity boosted mostly from debt refinances in those?

The cash yield equity boost is a little bit because that's recorded on a fair value basis and we had a slight reduction in fair value. On a dollars basis, I think the delta was actually down about $1.2 million from quarter to quarter in our structured credit book, which was primarily driven by the methodology for GAAP income recognition based on projective defaults, which a lot of times mirror our recent experience and more numbers going into kind of an LTM period or more recent kind of run rate period. So, I guess the flipside of that is, if you have a GAAP income recognition that's a tad less, is you reduce your cost basis. And we had about 10 percentage point differential between our cash yield and GAAP yield, which went to reduce our cost basis, and that's obviously a cushion for the future.

Got it. And how much of the CLO book do you think you'll be able to refinance the debt tranches over the next coming quarters?

It's difficult to project because refinancing windows can open and close, and sometimes that can happen quickly with changes in capital markets conditions. We've actually had a decent runway in the last few weeks to refinance deals and that's a runway that will continue post risk retention for certain deals of I think 2014 and before, you can still refinance under the rules. So it's difficult to tell. I would say we're actually working on another handful of opportunities. The markets can only digest so much at a given point in time, that is the liability purchasers who are getting pitched refinancing deals, they are getting pitched extension deals, and we've been active doing that to extend our reinvestment option to the maximum extent possible and is economically prudent to do so before risk retention kicks in and before the year end, and then of course there's new deal formation for primary issuance. So, you have kind of a times three deal type right now compared to a typical environment in the CLO market, which makes things extremely busy for arrangers, for collateral managers, for ourselves and our team, and the liability holders. So, we'll see how much we can get done but we're obviously trying to move forward expeditiously when it's economically prudent to do so.

Got it. And just your remarks on the consumer and looking at the online lending, and peer-to-peer lending has obviously been sort of troublesome with the trends in that lately, just wondering what you're seeing and what your thoughts are there and maybe if you're thinking of potentially scaling back that part of the business?

I would say we're not interested in scaling back that part of the business, but optimizing it with new data streams that come at us. One of the great things about this business is, you are purchasing an average of $10,000 loans on a fairly continuous basis on the consumer book, call it $50,000 average loans in the small and medium sized enterprises SME, small business lending book, and so you've got the ability to adjust course, tweak underwriting standards, et cetera, based on data streams that are coming at us. I would say that in general we've been pleased with our near prime consumer book performance and less pleased with our prime book performance, and having a higher ATR it turns out is a significantly positive cushion against defaults coming in other than as expected. So, near prime has been pretty much on par with expectation, prime a little bit less so at least with the relationship which we've been purchasing. So, I think you'll see us emphasizing more on the near prime. I would say also that the liability side of that business has really recovered nicely from some of the issues that surrounded one of the leaders in the marketplace in the June quarter, almost remarkably so, and we were able to get our first consumer securitization done in the last few weeks. So we're quite pleased with that and we think that should enable more access to credit and more future securitizations. They are a great matched-book funding and in profitable business and we see return on equity through those near prime securitizations as high-teens and approaching 20%. So, we'd like to grow that business. We do have capacity constraints as to how much we can do, but we're trying to optimize that complicated compliance aspect as well.

Got it. And can you just remind us if there's any existing passing of the repurchase program in place and what your appetite is for that versus new investments given the discount on the stock?

Yes, we have an authorization from the Board for $100 million of share repurchases. To date we've utilized about $34.3 million of that. We hit the pause button on that at the beginning of 2016 when we saw a significant amount of volatility come into the market with growth concerns, China concerns, et cetera, and were concerned about the impact that could have on valuations and on leverage ratios, et cetera. That's obviously a ratings negative with share repurchases, so you've got to balance that amidst everything else going on in the system and having ready access to the debt capital markets is very important for us, and we've continued to enjoy access in a number of different markets there. So we'll evaluate that going forward. I would say, when you look at returns we generated in some of these real estate investments, some of the returns I just indicated, and the online book where we've been deploying capital more recently, those look pretty attractive as well.

Got it. That's all for me. Thanks for taking my questions.

Our next question comes from Merrill Ross of Wunderlich. Please go ahead.

I noticed the recurring income as a percentage of investment income has increased over the past few years. It was in the high 70 percentile two years ago, and now it was 95% in this most recent quarter. Curious how you accomplished that, was it the reflecting an intentional shift in the way you do business or more was it a function of lower turnover?

It's really a function of the maturation of our business and the fact that we've achieved scale and have not been in growth mode for a little while. And when you think about two significant revenue streams for companies like ours, there's recurring interest and then there's upfront structuring fee, less recurring type of income. And for smaller lending credit book that's growing, you can enjoy higher earnings during growth mode because you're booking all those fees upfront, but the nature of those fees is less recurring and therefore arguably lower quality in nature than the interest types of fees. So, a more mature business with a high 95% recurring revenue mix, as we have, is arguably a much higher earnings quality stream business. That doesn't mean we don't like fee income as well. We of course are interested in that. And as we indicated in our prepared remarks, we're very focused on deploying capital but doing so thoughtfully. And candidly, in the current environment right now, there's a lot of irrational deals being done by others in the marketplace, there's been an uptick in capital that ventured primarily from the private marketplace with institutional funds raised, et cetera, that seems to need a home almost on a no-matter-what basis. So, we're maintaining discipline, we're in for the long haul, been around for a long time and we're not going to chase deals at imprudent leverage periods. And we're also mindful of the macro cycle and the fact that it's been nine years since the last recession and we generally underwrite to a recession occurring sometime in the next two to three years. And the numbers depends a lot accordingly with the loans that we make. I suspect others are not putting that into their base case expectations for underwriting.

It would seem that you have sufficient spill-over income that you don't need to chase deals. Are you completely willing to continue to draw down that income or would you readjust the dividend if you weren't able to get fully invested to your satisfaction?

Sure. We obviously used past of our Spillback in the prior quarter to support the dividend and we view that as an attractive storehouse of value. We used about $0.03 out of the $0.30 that we had approximately stored up in Spillback. So, that gives a reasonably long period of protection for us potentially, but we're focused on deploying capital and we expect to get more fully invested. But these things aren't always on a perfect conveyor belt as it pertains to deals and ones we're chasing versus what gets over at the goal line at the end of the day. But our teams are very focused on this and we expect to get fully invested.

Thank you.

I would say, right now, Merrill, looking at our – our pipeline shows about $300 million of what we call Category A originations between now and December 31. Those are deals where we have been mandated by a counterparty either under work letter or some other type of higher confidence level. That's not a guarantee that this deal will come into fruition, but it's an indication that we've got some pretty decent flow right now.

This is John. I appreciate your question because it reminds me of prior cycles. We've obviously been involved with your company for a very long time, going back to our IPO in 2004, and please say hello to Gary for me. Since then, we have lived through a number of cycles, the energy bubble, the syndicated loan bubble, the sponsor finance bubble, and at each time we backed away a bit from what we thought was an overheated market and have been happy to have done so. So, we're in business for the long haul, not the short haul, and as a result we have not been able to get reinvested as quickly as we would have liked. But then again, we have maintained our underwriting standards, our diligence standards and our hurdle rates. So, it will take a little longer but we think we'll benefit over the long-term by being careful and prudent.

Thank you.

Yes, and say hi to Gary please.

Our next question comes from Casey Alexander of Compass Point Research. Please go ahead.

I'm sure I'm going to ask this badly, all right, but were your originations in the September quarter sort of back-ended, and if so, coming out of the quarter what was sort of your natural NII run rate? And understanding that in the absence of Harbortouch, there's been, there is in this quarter some shortage of NII to the dividend, do you need to run a little bit higher target leverage ratio in order to naturally cover the dividend with net investment income? I'm sorry to chop it up that way but I think you get the idea.

Yes, I think we got this.

I think it's a great question if you ask me.

I'll take the second piece first. Net of cash, we're someone in the low 70s, which is on the 70% debt-to-equity as of 9/30. So, we're on the lower end and we need to be higher in that range from a coverage standpoint. I think that's fairly plain to see. Our originations were somewhat back-ended at the end of the quarter, and that sometimes happens. Closings often times are clustered either at month-end or at quarter-end for the change of control, convenience purposes and moving over for new buyer accounting, et cetera, as an action forcing that I guess for some of these deals. We have had some repayments however at the beginning of the current quarter as we have announced. So in the quarter-to-date, we've actually had net repayments rather than originations. So, we've got a decent amount of dry powder to put to work right now. It would be hard to take all those moving parts for end of the quarter and since the quarter and quote something run rate right now. It's been I think better for us to just deploy this capital.

Okay, all right. Thank you. Recently, I think it was announced that you guys set up – that the advisor set up a private partnership for a portfolio of online lending loans. Is that correct?

No, that's not ringing a bell to me.

Okay, all right. Thinking of something else. My bad. All right, thank you for taking my questions. I appreciate it.

Very nice questions. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Barry for any closing remarks.

Thank you everyone for joining our conference call. We greatly appreciate your interest in Prospect and I think it's time we all go back to work. What do you say, Grier, Brian?

Certainly.

Okay, thanks all. Bye.

Thanks all. Bye now.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.