Prospect Capital Corporation (PSEC) Q4 2017 Earnings Report, Transcript and Summary

Good morning. And welcome to the Prospect Capital Corporation Fiscal Year Earnings Release and Conference 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, Prospect Capital's Chairman and CEO. Please go ahead.

Thank you, Anita. 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 earnings press release, our 10-K, 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. Before we begin today, each of us at Prospect is thinking about our portfolio company employees, shareholders, family members, friends and people anywhere, suffering from the devastation of hurricane Harvey over recent and coming days. We pray for speedy recovery. For the June 2017 fiscal quarter, our net investment income or NII was $69.7 million or $0.19 per share, down a penny from the prior quarter; carrying out our plan to reduce risk, decreased originations, structuring fees and management fees; executing our plan to preserve capital, reduce risk and avoid chasing yield through investments, presenting a weak risk reward profile. At this point in the economic cycle, we reduced originations this quarter to about half of the levels of the prior quarter. We remain committed to our history credit discipline. Credit quality and yield. We believe our discipline approach to credit will serve us well in the coming years, just as that disciplined approach has served us well over multiple credit cycles. In the June 2017 quarter, we also reduced risk by decreasing our net debt to equity ratio for 75.6% at March 2017 to 70.5% at June 2017. Our net income was $51.2 million or $0.14 per share, up $0.09 from the prior quarter due to lower management fees and reversals of unrealized depreciation in our energy consumer finance and structured credit investments in the June 2017 quarter compared to the March 2017 quarter. For the fiscal year ended June 2017, our net investment income was $306.1 million or $0.85 per share, down $0.19 from the prior year. Our net income was $252.9 million or $0.70 per share, up $0.41 from the prior year. We are pursuing multiple strategies to enhance our income over the coming years. On the asset management side; we are processing a robust pipeline of new originations; enhancing cash flows and our structured credit portfolio through extensions, refinancing and calls; optimizing NPRC’s online lending business through securitization and refinance; these multifamily real estate portfolio improving controlled investment operating performance and enhancing yields through higher floating rate LIBOR based rates. On the liability management side, we plan on continuing ways to lower our cost of capital through a combination of increased revolver utilization and lower coupon new term issuance. We are announcing monthly cash distributions to shareholders of $0.06 per share for September and October 2017, marking 111 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in November. Since our IPO 13 years ago, through our October 2017 distribution at our current share count, we will have paid out $16.07 per share to original shareholders, exceeding $2.3 billion in cumulative distributions to all shareholders. Our NAV stood at $9.32 per share in June 2017, down $0.11 from the prior quarter. Our balance sheet as of June 30, 2017 consisted of 90.4% floating rate interest earning assets and 99.9% fixed rate liabilities, positioning us to benefit from rate increases. Our recurring income, as measured by our percentage of total investment income from interest income, was 96.3% in the June 2017 quarter, further reducing the contribution of one-time structuring fees in favor of recurring interest income. We believe there is no greater alignment between management and shareholders than from manage to purchase a significant amount of stock particularly when management has purchased stock on the same basis as other shareholders in the open market. Prospect management is the largest shareholder in Prospect, and has never sold a share. Management, on a combined basis, has purchased that cost over $175 million of stock in Prospect, including over $100 million of stock since December 2015. Our management team has lived in the investment business for decades with experience navigating both challenges and opportunities presented by dynamic economic and interest rate cycles. We have learned when it's more productive to reduce risk than to reach free yield. The current environment is one of those times. We believe the future will provide us with attractive opportunities to purchase income earning assets, utilizing the dry powder we have built and reserved for that purpose. Thank you. Now, I’ll turn the call over to Grier.

Thanks, John. Our scale business with over $6 billion of assets and undrawn credit continues to deliver solid performance. Our experienced team consists of approximately 100 professional, representing one of the largest 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 June 2017, our controlled investments at fair value stood at 32.7% 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 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 the preference for secured lending and senior loans. As of June 2017, our portfolio at fair value comprised; 48.3%, secured first-lien; 19.1%, secured second lien; 18.5%, structure credit with underlying secured first lien loan collateral; 0.1%, small business whole loans; 0.8%, unsecured debt; and 13.2% equity investments, resulting in 86% of our investments being assets with underlying secured debt benefiting from borrower pledge collateral. Prospect’s approach is one that generates attractive risk adjusted yields. And our debt investments were generating an annualized yield of 12.2% as of June 2017, down 0.1% from the prior quarter due to continued asset spread compression in the market. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generates distribution. We have continued to prioritize first-lien senior and secured debt with our originations to protect against downside risk, while still achieving above the market yields through credit section discipline and a differentiated origination approach. As of June 2017, we held 121 portfolio companies with a fair value of $5.84 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 10.7%. As of June 2017, our asset concentration in the energy industry stood at 2.4%, including our first lien senior secured loans where third parties bear first loss capital risk. Non-accruals, as a percentage of total assets excluding one investment which timely paid our income producing contractual interest in the June 2017 quarter, stood at approximately 1.2% in June 2017, down 0.2% from the prior quarter with approximately 0.2% residing in the energy industry. Our weighted average portfolio net leverage stood at 4.19 times EBITDA, up slightly from 4.15 times the prior quarter. Our weighted average per portfolio-company stood at $48.3 million in June 2017, down from $49.4 million in March 2017. 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 non-anchor 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 2017 quarter aggregated $223 million, down from $450 million in the prior quarter. We also experienced $352 million of repayments and exits as the validation of our capital preservation objectives, up from $303 million in the prior quarter, resulting in net repayments of $129 million compared to net originations of $147 million in the prior quarter. During the June 2017 quarter, our originations comprised 32% structured credit, 31% third-party sponsor deals, 31% syndicated debt, including early look anchoring investments and club investments, 4% online lending, 1% real estate and 1% operating buyouts. 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 June 2016 quarter, we consolidated our REITs into NPRC. NPRC's real estate portfolio has benefited from rising rents, strong occupancies, high returning value-added renovation programs, and attractive financing recapitalizations, resulting in an increase in cash yields as a validation of this income growth business alongside our corporate credit businesses. NPRC has exited completely certain properties, including Vista, Abbington, Bexley and Mission Gate, with an objective to redeploy capital into new property acquisitions. We expect both recapitalization and exits to continue. NPRC also, in the past year, closed its first portfolio investment in student housing in attractive segments similar to multi-family residential where we have analyzed many opportunities for several years. In addition to NPRC's significant real estate asset portfolio, over the past few years, NPRC and we have grown our online lending portfolio with a focus on super-prime, prime and near prime consumer and small business borrowers. This online business, which includes attractive advanced rate financing for certain assets, is currently delivering more than 12% annualized return net of all costs and expected losses. In the past four years, we and NPRC have closed five bank credit facilities and three securitizations, including in the June 2017 quarter, NPRC's second consumer securitization to support the online business with more securitizations expected in the future. NPRC is focused on expanding its most productive online lending platform activity, while refinancing and redeploying capital from other online platforms. 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 2017, we held $1.1 billion across 43 non-recourse structured credit investments. The underlying structured credit portfolio is comprised around 2,500 loans and a total asset base of over $19 billion. As of June 2017, our structured credit portfolio experienced a trailing 12-month default rate of 75 basis points, a decline of 30 basis points from the prior quarter and 79 basis points less than the broadly syndicated market default rate of 154 basis points. This 79 basis point outperformance was up from 44 basis point outperformance in the March 2017 quarter. In the June 2017 quarter, this structured credit portfolio generated an annualized cash yield of 18.8%, up 0.9% from the prior quarter and a GAAP yield of 13.6% stable with the prior quarter. As of June 2017, our existing structured credit portfolio has generated $939 million in cumulative cash distributions to us, representing 64% of our original investment. Through June 2017, 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 trench. In many cases, we received fee rebates 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, remove bond baskets in exchange for better terms and debt investors in the deal, and extend or reset the investment period to enhance value. Our structured credit equity portfolio has paid us an average 21.4% cash yield in the last 12 months. So far, the current September 2017 quarter, we booked $42 million in originations and received repayments of $142 million, resulting in net repayments of $100 million. Our originations have comprised 43% syndicated and club debt, 38% online lending, 12% third party sponsor deals and 7% real estate. Thank you. I’ll now turn the call over to Brian.

Thanks, Grier. We believe our prudent leverage, diversified access to match book funding, substantial majority of unencumbered assets and weighting towards unsecured fix rate debt, demonstrate both balance sheet strength, as well as substantial liquidity to capitalize on attractive opportunities. Our Company has locked in ladder of fixed rate liabilities, extending over 25 years into the future, while the significant majority of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise. We are a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, develop our notes program, issue an institutional bond, acquire another BDCs, along with many other 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 2017, we had approximately $4.6 billion of our assets as unencumbered assets, representing approximately 74% of our portfolio. The remaining assets are pledged to prospect capital funding, which has a double 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 a one year amortization period 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 BBB rating from Kroll and investment grade BBB minus rating from S&P. We've now tapped the unsecured term debt market on multiple occasions to ladder our maturities and extend our liability duration more than 25 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we substantially reduced our counterparty risk over the years. We have refinanced three non-program term debt maturities in the past three years, 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. In the June 2017 quarter, we issued 4.95%, $225 million convertible bond, utilizing a substantial amount of the proceeds to repurchase bonds maturing in the upcoming year. We have also called $139 million of our program notes maturing through September 2019. For the remainder of calendar year 2017, we have liability maturities of $61 million. 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 the calendar year 2016 during market volatility. We now have eight separate unsecured debt issuances, aggregating $1.7 billion, not including our program notes with maturities ranging from October 2017 to June 2024. As of June 31, 2017, we had $981 million of program notes outstanding with staggered maturities through October 2043. Now, I'll turn the call back over John.

Thank you very much, Brian. We can now take questions.

We will now begin the question-and-answer session [Operator Instructions]. The first question comes from Christopher Testa with National Securities Corporation. Please go ahead.

I'd just like to start off on the non-accruals. So, United Sporting was a new one this quarter. Last quarter, you had it marked at 94 and it dropped to 59, which is pretty rapid of a decline and the value. Just curious if you can provide some color on that situation.

I think Grier would like to talk about United Sporting, because he’s sure very familiar with that.

So two items, overall, it was really impacting that business, one of which is, I would describe is a cyclical one, which is when there is elections that go certain way that, there to be a slowdown in sales to the firearms sector for the first six or nine months or so. And then there is more of normalization thereafter. That’s what we’ve observed studying data over long periods of time. But I think in terms of the short term fashion that you referenced, there is a bankruptcy in the retail space a major customer, Gander Mountain, whether there are some credit losses Hopefully, onetime in nature where other types of customers and including independents that don’t suffer as much from in online threat in this particular segment for regulatory background check clearance reasons, there’s really not in online business and for a lot of it. Then hopefully, that will pick up this slack. So we shall see. So we have a very strict non-accrual policy, which means that we can sometimes put assets on non-accrual even if they are still paying us. And for clarity, non-accrual does not mean no income recognition, non-accrual means you recognize income as you receive payments, and that’s subject to further testing as well. But you’re not accruing income in between periods. So technically, this is a non-accrual. We wanted to highlight it’s a paying non-accrual as opposed to non-paying non-accrual. Hopefully that helps to answer your question, Chris.

No, it does. But if it’s still paying you, I’m just curious why it’s marked under 60?

Well, the Company’s has experienced some short-term stress pertaining to Gander bankruptcy, which severely impacted earnings short-term through the reasons I just talked about. We’re hoping to see recovery out of that asset.

And just moving on with the non-accruals, if I look at Edmentum, I know you have that the unsecured tick note on non-accrual. There’s some tranches in front of it are marked after value. Just curious in that structure, how much first lien debt in senior to you to the extent that you’re able to disclose that?

I don’t have that at my fingertips right now, Chris. And we have to check in and see what we’re able to disclose. And we’re subject to confidentiality with these private of companies. So we can’t always disclose every last thing about the companies we’re invested in. So we’ll have to check that. That’s a club deal. We’re one of multiple lenders in the education space. A new Chief Executive Officer was just hired for that company that the lender/equity group is very excited about. They just tend to be in annual sales cycle aspect that it's just wrapped up. So the impact of the new leadership would likely not occur until the sales cycle of the following year in calendar year 2018, commensurate with the 2018-2019 school year.

And of the non-accruals exited during the quarter, they’re no longer on non-accrual whether it was restructured or sold. You have realized -- unrealized, losses of $68.3 million, the realized losses during the quarter were roughly $97 million. Just what made up the difference? Was there one non-accrual restructure significantly below of mark that you had it out, was there something else that occurred? Just any color there is appreciated.

Really the biggest part of that realization, the reference was a company called, Gulf Coast, GulfCo, which is a company that we took over several years ago, a forging business, serving the oil and gas industry. And worked very hard, we basically had people onsite at the company and I think there's multiple people, virtually every business-day since taking over ownership, and trying to rehabilitate the business. And what we concluded about that business was based on the fixed cost structure of the business and the new paradigm through the oil and gas industry and the new margin reality. We did not see a viable path to recovery any sort of investible future. So we took the prudent path and sold the asset to a strategic that could cash our synergies that we could not on a standalone basis. So obviously, not an outcome that we had targeted, but really a casualty of the significant fall off in the oil and gas industry that has been the primary credit events since 2014 impacting us; luckily not as much as perhaps others. And John anything you want to add to that?

Well, just that I don't know how much I can add to what you've just said, other than to say. These loans, where we end up in a restructuring situation, sometimes can turnaround and provide an equity return and one that Chris I'm surprised you haven't asked about, since you seem very on top of Edmentum, UFC, GulfCo, I'm quite impressed. There's a fourth one in there where I'm personally hopeful for an equity upside in a restructured deal. So that’s I have to add there, Grier. Anything else Chris, from you?

Yes, just last one from me, and then I'll hop back in the queue here. Just looking at the structured credit, obviously, yields are across the board under pressure from the reinvestment environment being challenging. Just curious, do you have a certain percentage of your book based on the vintage basis that you're able to call each quarter with certain number of deals or refinance them? And to the extent that you're able to do that, are you guys of the mindset now that it's best to refinance everything you can or are you waiting for a potential further spread compression where you might get even better refi terms on the CLOs in the coming quarters?

Well, Chris that’s another great question. What we’ve done is examine -- because we are the majority owner of the equity of the PSEC CLOs, we have the right to call the right to redeem, the right to repack, the right to reset, many rights that we find provide significant option value to us in a dynamic rate environment. I think everyone knows what I mean by dynamic rate environment these days with the wall of money, billing new money, managed by people with limited experience in our marketplace. With that wall of money coming into our marketplace we’ve seen significant spread compression, significant yield compression across the board. And the last time this happened, it was also the result of new money coming into our market in 2006. Many of those new money credit managers trying their hand to credit for the first time are no longer in business. Will that happen now? We’ll see. We intend to stay in business, obviously. In the CLO business, the spread compression and yield compression has been as evident as anywhere else. And I know, Chris, you’re aware of this. But just to state the obvious, borrowers can refi, borrowers can just go to a lender and say, well, I’m going to refi; I’m getting all these calls from brand new competitors of Prospect; I’m hearing I can reduce the interest rates of my loans by 100 basis points tomorrow. So why don’t you just agree now to reduce the interest rate on the existing loan and we can save both parties a lot of friction. So it’s that easy. In our CLO book, which is hundreds, I guess maybe thousands of loans that process continues to pace. What we can do? We can reprise, reset, repack, refi the liabilities, which we have been doing. Because we own the majority positions in our CLOs, we are able to look at every single one and examine whether we should, refi, reset, repack, call and the like. And I’m sure Chris since you seem very on top of this you’ve seen what we’ve been doing. I would say that we – I can say we have examined every single CLO in the book to see what is the best optimizing strategy. In some cases it’s a reset, in some cases it’s a refi, in some case it’s a redemption or call. So it varies from CLO to CLO. I’m sure, as you’re aware that there are restrictions in the Dodd-Frank risk retention rules that limit how many refis you can do, the time period during which you can refi. And the result of that is that, generally, one of the trickiest questions is; first, when is the last -- can we refi this. Is it one of the CLOs that can be refied? And if so, what is the deadline of doing that? And once we know what the deadline is, we then have to ask ourselves what do we think is going to happen with spreads and interest rates. Now, as Keyes said, there is two opinions on interest rates; one coming from people who don’t know where interest rates are going; and the other coming from people who don't know that they don't know where interest rates are going. So we have no more ability than John Maynard Keynes to predict interest rates; except for one thing, we can look at the calendar. And when we look at the calendar, we can see how many issuers CLO reset issuers are trying to squeeze through a particular window. And if it's too many, at one time, we know that the pace will be slower and that we may not be able to pick the exact day. And then we get into the deadline problem. We don't want to pass the deadline for doing this whether it's in the documents or is part of Dodd-Frank. For example, Dodd-Frank has a provision in there in the law in the regs that allows one refi prior to, I forget what it is, December 2017. You want to choose the optimal time when you will refi prior to that deadline day. And another factor that you're going to be considering is how big is this CLO, how much money will it draw from the marketplace, what is the duration. If you've got one that has six years to go and another that has six months to go, you are going to not waste your refi bullets on the six month CLO, but instead you're going to refi the six year CLO. Well, that would be true if each had the same cost of capital. Well, what if the longer duration CLO has a lower cost of capital than the shorter duration CLO? Now, you have to think, oh, what is the bank for the buck doing A versus B. So those are kinds of analysis we go through. I think your question was have we examined every single one? And we have. I don't have the exact numbers of how many, maybe Brian does. I gave that amount in the last earnings call, and the numbers have changed. How many we've reset, how many we've refied, how many we've repacked, how many we've called, how many we've redeemed? Brian, do you have those numbers? Grier, do you?

While Brian is looking that up, I want to make sure we -- I answer Chris' specific question, which I thought was how do you decide if you want to do the refi now as opposed to X numbers of months from now. And the answer, Chris, is we do a metrics where we show what the IRRs are going to be of each time period with a reasonable band of assumptions about the future. And we try to pick the time period that’s going to optimize the IRR. But there is now a new overlay on top of that, Chris, which is we want to make sure in structured credit business, CLO business, you want to make sure you don’t have your option truncated when collateral values are low. Which is a long way of saying, you want to have deal ending when our session is just starting, or you’re in middle of recession. So we have a stronger bias toward extensions and calls into new deals, which are de facto extensions as you use a lot of the same collateral, because then we’re really extending the maturity of the overall deal. And we’re -- I’ve heard as pole-vaulting over the next recession. So you have locked-in liabilities and you’re benefiting substantially from enhanced volatility and therefore option value. So, it’s a pretty complex analysis, but shows how active management this book really is.

And I might have – I’ve missed if I know you guys usually say. What was the cash on GAAP yields on the CLO book this quarter, Grier?

Sure. We have it in our releases, 13.6% on the GAAP side and the cash side was about 18.8%. So the GAAP yield is actually pretty stable, Chris, and shows you’ve had continued spread compression that has been compensated virtually equally by the benefit of reducing our liability cost and also lowering a discount rates for this paper. It’s become more challenging to find high returning paper. But we’ve been really in a reinvestment mode as opposed to a, grow the book, mode for this business within PSEC anyways. But the team is seeing, so far, spread stabilization in a broadly syndicated market. I would say that is not the case in the middle market where more money continues to pore in from the private institutional marketplace, and into that side, which has led us to spend a lot more time on smaller deals, on non-sponsor deals and on saying, look, sometimes you have to except spread compression to stay in one-else spot as opposed to chase higher risks, junior debt situations are over-leverage situations, which is really part in parcel of what John was talking about the beginning of the call was with risk management and proper underwriting, and not chasing irrational deals that we’re seeing done in the marketplace, particularly here in the 2017.

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

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