Prospect Capital Corporation (PSEC) Q1 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the Prospect Capital Corporation First Fiscal Quarter Earnings Release Conference Call. All participants will be in listen-only mode. [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, Kate. Joining me on the call this morning 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-Q and our corporate presentation filed previously and available on the Investor Relations tab of our website, prospectstreet.com. Now, I will turn the call back over to John.

Thank you, Brian. For the September 2017 fiscal quarter, our net investment income or NII was $63.7 million, $0.18 per share, down $0.01 from the prior quarter and equal to our current dividends. Executing our plan to preserve capital, reduce risk and avoid chasing yield through investments, being too risky, with poor risk return profiles at this point in the cycle, we booked originations this quarter in line with the prior quarter. We remain committed to our store credit discipline. We currently have a robust pipeline of potential investments in our target range for credit quality and yields. We believe our disciplined approach to credit will serve us well in the coming years just as that disciplined approach has served us well in past years. In the September quarter, we maintained – actually reduced to 71.6% our net debt to equity ratio, down 200 basis points from a year ago. Our net income was $2 million or $0.03 per share, down $0.11 from the prior quarter due to unrealized depreciation within our structured credit investments and a lower interest earning asset base. In the September quarter over the June quarter. We are working to execute on a robust pipeline of new originations, improving cash flows in our structured credit portfolio, including through extensions, refinancings, calls and refax, optimizing NPRC’s online lending business, including through securitizations and refinancings, increasing realizations in NPRC’s 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 lowering our weighted average 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 November, December and January, representing 114 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in February. Since our IPO, 13 years ago through January 2018, distribution at our current share count we will have paid out $16.26 per share to original shareholders exceeding $2.4 billion in cumulative distributions to all shareholders. Our NAV stood at $9.12 per share in September, down $0.20 in the prior quarter. Our balance sheet as of September 30 consisted of 90.45% 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 93% in the September quarter. We believe there is no greater alignment between management and shareholders than for management to purchase and own over long periods of time a significant amount of company’s stock, especially when management has purchased that stock on the same basis as other shareholders in the open market and not with the benefit of options. Prospect’s management is the largest shareholder in Prospect and has never sold the share. Management on a combined basis has purchased that cost more than $175 million of stock in Prospect, including over $100 hundred since December 2015. Our management team has been in the investment business for decades, with experience handling both challenges and opportunities served up by dynamic economic and interest rate cycles. We have learned when it is more productive to reduce risk than to reach free yield and we believe the current environment is one of those time periods. At the same time, we believe the future will provide us with substantial opportunities to purchase attractive assets utilizing the dry powder we have built and reserved. Thank you. I will now turn the call over to Grier.

Thank you, John. Our scale business with around $6 billion of assets and undrawn credit continues to deliver solid performance. Our experienced team consists of approximately 100 professionals 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 September 2017, our controlled investments at fair value stood at 34% of our portfolio. This diversity allows us to source a broad range and high volume of opportunities that selected 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 2017, our portfolio at fair value comprised 48.5% secured first lien, 19.5% secured second lien, 17.0% structured credit with underlying secured first lien collateral, 0.1% small business whole loans, 0.8% unsecured debt and 14.3% equity investment resulting in around 85% 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 are performing debt investments were generating an annualized yield of 11.8% as of September 2017, down 40 basis points 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 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 2017, we held 120 portfolio companies with a fair value of $5.69 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 11.2%. As of September 2017, our asset concentration in the energy industry stood at 2.7% and our concentration in the retail industry stood at 0%. Non-accruals as a percentage of total assets stood at approximately 2.1% in September 2017 down 40 basis points in the prior quarter. Our weighted average portfolio net leverage stood at 4.32 times EBITDA, up from 4.19 the prior quarter. Our weighted average EBITDA per portfolio company stood at $49.2 million in September 2017, up from $48.3 million in June 2017. The majority of our portfolio consists of sole agented and self originated middle-market loans. In recent years, we 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 September 2017 quarter aggregated $222 million, nearly the same as $223 million in the prior quarter. We also experienced $258 million of repayments and exits as the validation of our capital preservation objective resulting in net repayments of $35 million. During the September 2017 quarter, our originations comprised 47% agented sponsor debt, 34% non-agented debt, including early look anchoring and club investments, 17% online lending and 2% real state. Today, we have made multiple investments in the real state 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. 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, this most recent quarter, with an objective to redeploy capital into new property acquisitions as we have been doing in the quarter-to-date. We expect both recapitalizations and exits to continue and NPRC has multiple exits pending with attractive expected realized returns. NPRC is recently rate locked and closed two acquisitions with a repeat property management relationship, with a strong track record, with more acquisitions expected. In addition to NPRC significant real estate asset portfolio over the past 2 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 advance rate financing for certain assets, is currently delivering more than 12% annualized return net of all costs and expected losses. In the past 4 years, we, at NPRC, have closed 5 bank credit facilities and 3 securitizations including at the end of the June 2017 quarter, NPRC’s second consumer securitization to support the online business. NPRC is currently working on its third consumer securitization as well as a recapitalization of multiplatform assets. 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 initial 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 2017, we held $1.0 billion across 43 non-recourse structured credit investments. The underlying structure credit portfolios comprised over 2,300 loans and a total asset base of over $19 billion. As of September 2017, our structured credit portfolio experienced a trailing 12-month default rate of 55 basis points, a decline of 20 basis points in the prior quarter and 98 basis points less than the broadly syndicated market default rate of 153 basis points. This 98 basis points outperformance was up from 79 basis points in the June 2017 quarter. In the September 2017 quarter, this portfolio generated an annualized cash yield of 18.3%, down 50 basis points from the prior quarter and a GAAP yield of 12.4%, down 120 basis points in the prior quarter. As of September 2017, our existing structured credit portfolio has generated $1 billion in cumulative cash distributions to us, representing 70% of our original investment. Through September 2017, we have also exited 11 investments totaling $291 million, with an average realized IRR of 16.3% and cash-on-cash multiple of 1.49x. Our structured credit portfolio consists entirely of majority-owned physicians. Such physicians can enjoy significant benefits compared to minority holdings in the same tranche. In many cases, we received fee rebates because of our majority position. As 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 from debt investors in the deal, and extend also known as reset the investment period to enhance value. Our structured credit equity portfolio has paid us an average 20.5% cash yield in the 12 months ended September 30, 2017. So far in the current December 2017 quarter, we booked $126 million in originations and received zero repayments resulting in net originations of $126 million. Our originations have comprised 59% non-agented debt, 32% real estate, 6% agented sponsor debt and 3% operating buyouts. Thank you. I will now turn the call over to Brian.

Thanks, Grier. We believe our prudent leverage, diversified access to matchbook 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 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. Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry, which we have taken towards construction of the right hand side of our balance sheet. As of September 2017, we held approximately $4.5 billion of our assets as unencumbered assets, representing approximately 75% of our portfolio. The remaining assets are pledged to Prospect capital funding, which has a AA rated $885 million revolver, with 21 banks and with a $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 1 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, no cross defaults with our revolver. We enjoy an investment grade rating of BBB plus from Kroll and investment grade BBB minus rating from S&P, which was recently reaffirmed. We have now tapped the unsecured debt market on multiple occasions to ladder our maturities and to 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 have substantially reduced our counterparty risk over the years. We refinanced four non-program term debt maturities in the past 3 years, including our $100 million baby bond in May 2015, our $150 million convertible note in December 2015, our $167.5 million convertible note in August 2016, and our $50.7 million convertible note in October 2017, the latter of which we had also significantly repurchased in the June 2017 quarter. In the June 2017 quarter, we issued a 4.95%, $225 million July 2022 convertible bond utilizing a substantial amount of proceeds to repurchase bonds maturing in the upcoming year. We have also called the – called $222 million of our program notes maturing through November 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 allowing payments and exits to come in during the ordinary course as we demonstrated the first half of calendar year 2016 during market volatility. We now have 7 separate unsecured debt issuances aggregating $1.7 billion, not including our program notes, but maturities ranging from March 2018 to June 2024. As of September 30, 2017, we had $916 million of program notes outstanding with staggered maturities through October 2043. Now, I will turn the call back over to John.

Hey, thank you, Brian. We can now answer any questions.

[Operator Instructions] The first question comes from Leslie Vandegrift of Raymond James. Please go ahead.

Hi, guys. Just a quick question on the market, we saw the markdowns on structured credit, which you mentioned in the comments. Just wanted to get a bit more color there and where you see that going this quarter and into 2018?

Sure, Leslie, thank you for that excellent question. It’s difficult to tell sitting here in November 9 what the state of play will be from a valuation perspective on December 31, which is 7 weeks from now, but in general in the quarter that just wrapped up, the factor of asset spread compression outweighed as a negative factor on the valuation front, positive factors, including an increase in LIBOR, an increase in – rather a reduction in trailing 12-month default rates in which we have significantly outperformed the market and in general, a reduction in discount rates for this type of paper of these securities. There is a lot of capital out there chasing floating rate right now and that’s true not just in the broadly syndicated market, but also the core middle-market business impacting a lot of people in the industry right now, which is why we are being ultra cautious and you have seen us not stop on the gas pedal for new originations, we are passing at a lot of deals right now. But within structured credit, it’s difficult to tell with asset spread compression will continue. Some of it is being enabled by in the structured credit business a reduction in liability of spreads. So, the question is at what point you hit a floor for what say AAA investors will expect to get paid as a spread that impacts then, how much arbitrage is available on the asset side of the ledger. As we have talked about historically in CLOs and structured credit, your two general risk or at times being too good and times being too bad. Too good means a time of declining spreads. Too bad means the time of spiking default rates. The latter generally is worse than the former. We are in the former range right now times being too good, but we do have benefit and that many loans are trading at a premium to par right now or robustly valued on an underlying basis. And we do have the ability if spread compression worsens to call deals and to call at favorable prices and to take that capital and redeploy into other places. Note, we are very, very cautious not just on the valuation front, but also which is 100% third-party driven, but also on income recognition, which I think is an important point that’s oftentimes lost in the picture. And that was the reason for some pressure on the income side of things that the reduction in net investment income yield in the quarter, notice that the recognized GAAP net investment income driving yields for structured credit was significantly below our cash yields. That means, we are conservatively taking a significant portion of our cash proceeds about a third and utilizing that to reduce our cost basis. And that’s about 500 basis points less than income recognition that others are doing in the marketplace as a highly conservative accounting focus within our structured credit business, only about two-thirds of every dollar of cash we received is recognized as income, the other third goes to reduce our cost base. That’s also of course a storehouse and piggybank protection for the future as well. Any follow-up questions there, Leslie.

Yes. Just one on, so if being a bit more conservative on that price right now, but you also mentioned in the prepared remarks, 34% of the portfolio is now on the control side now just kind of with those issues right now on the CLOs whether because it’s too good or wherever it is in the cycle, are you going to focus on doing more of the like online lending more of the traditional controlled companies on your portfolio, where is the other route there?

Sure. We have been in the low 30s in kind of the controlled investment side for a while now. That does not include that CLO business. The structured credit business which actually declined to about 17% of our book in part through the write-down in part through not making much in the way of significant new investments in that business. And one chunk of that control piece, the biggest singular chunk is NPRC, of which a majority of which is our real estate business. Our real estate business has arguably been one of our best performing businesses recently, a real bright spot and we are quite pleased with the performance of business. We have generated something or we meaning NPRC has generated something like a 30% realized internal rate of return on exited deals that have gone the distance. And as we mentioned in our prepared remarks, we have got other exits as well. We are constantly evaluating the hold, sell and force purchase new properties optimization and we prune the properties we deem important to do so where we have already captured the value from a renovation program. So, we are selling properties and we are also buying new properties this quarter today the December quarter has been particularly active for that. We have already closed two significant deals and we have got others who are planning and we continue to find interesting pocket. There is a lot of capital out there sort of everywhere in all asset classes, but on a relative basis, interestingly our view is real estate has less than corporate credit right now, which I think is something to do with how institutional investors have allocated in the last year or two to anything touching a floating rate. So, we like the real estate business, it’s not technically credit business, it’s an equity business, but it’s heavy cash yield business, the most credit like with diversified counterparty exposure, multifamily. That’s a great inflation hedge. That’s a great beneficiary of attractive financing and we lock in for 10 years, we don’t gamble on interest rates. So, we have a really long time horizon of locked in financing. We have got the ability to do dividend recaps when properties significantly outperform as we have done in significant parts of the real estate portfolio to monetize our position and then redeploy. So, we are very, very pleased with that business. It’s a low hit rate business in terms of a book-to-book ratio, but that’s part and parcel of our business. Elsewhere in the control side, you’ll see us continue to selectively look at other control investments. We have been doing add-on acquisition opportunities for Mighty Lake, for example, which is a furniture maker that addresses the hospitality and restaurant and many other – the institutional and hospital segments as well and we have been finding attractive places to deploy capital there. And you will see us selectively look at other deals, where we have a competitive advantage of being able to supply one-stop capital. You are not typically going to see us chase deals at high valuations or quite value driven. And then there is our financial buy-outs also in the control book, which is largely in consumer credit, two installment lenders and one auto finance business and you are seeing an increase in charge-offs earlier in calendar year 2017. We are pleased to see improvement there and we think many of those businesses are turning the corner and are starting to bottom out and show growth again. And you are also seeing a much more favorable regulatory environment right now for those types of businesses than with the case a year or two ago. So, it’s all bottoms up deal-by-deal and looking for attractive place to deploy capital, but the control book is certainly one area. And another important aspect to mention is when you own a business or position if you decide to sell it, it’s your decision, one of the very tough things about the credit side, the corporate credit side middle-market is when a credit does particularly well, you either have to put up more money to recap it or you get paid off, spreads are fleeting and repayments really can spike. We even had any so far this quarter, but we have had periods of significant repayments and we expect that will be the case as well from time-to-time in the future. So, you could hang on to a steady recurring cash flow business and I now have to constantly be redeploying like you do on the credit side of thing. So, there is a lot of advantages to the control book.

Alright. Well, thank you for answering the questions and all the color on that. Appreciate it.

Thank you, Leslie.

Your next question is from Christopher Testa of National Securities Corporation. Please go ahead.

Hi, good morning. Thanks for taking my questions. Just looking at the challenging loan market environment, where you guys are trading in the dividend yield, just wondering why you are not massively repurchasing stock?

Chris, thank you for your question, we have repurchased stock in the past, we have about $100 million authorization from the board, for repurchases, I think we have used about a third of that to-date. We had slowed buybacks previously, because we are worried about the volatility impact on leverage. Circumstances can change pretty swiftly 2 years ago, 1.5 year, end of 2015, early 2016. Folks thought we are about to hit another recession and you had a huge uptick in volatility. The rating agencies have made it crystal clear to us and I think others in the industry that buybacks are big negative from a rating standpoint, which makes us cautious and we need to be careful in managing other compliance baskets that are critical to manage from a legal and tax standpoint, including our 30% basket. If we get a big surge in repayments coming out of the 70% basket and you end up off-sized on the 30% basket, which is an incurrence, not a maintenance test. It means you actually can’t put in a single $0.01 into a 30% basket investment even something that might have a 200% IRR attached to it like some of the resets and areas in our structured credit business or attractive synergistic add-ons that we are exploring for example in our financial services portfolio. So, we should be careful about that. We should be careful about our diversity tests as well in other aspects where scale is important. We have earned on the real estate size I mentioned 30% IRRs approximately within NPRC and Richardson actively redeploying capital there. So, those are some of the factors, Chris, which I would say makes it an ongoing discussion item for the business.

I can understand those points, but I mean what type of discount and risk less return on capital from accretive buybacks would the board need to induce them to actually implement the program and you guys actually do it?

Yes. Chris, it doesn’t come down to one number, the cost of not complying the cost of having liability access issues, those can be incalculable as well. So, it’s a multifactor analysis, Chris. It doesn’t come down to one simple formulaic number.

Okay, that’s fair. And just touching on the online consumer lending business, just wondering if your outlook on that business has changed given the kind of tepid results coming out of Lending Club and On Deck?

Sure. Well, with On Deck, that’s always been a very small part of our business. I think how big is that book right now, Brian, $15 million maybe it’s a tiny part of our business.

I understand. I just mean, but it’s in the same line of business as what you are doing in the online?

Yes. The small business lending has always been a very small business in part because originators liked it when you mentioned have become balance sheet lenders themselves as opposed to sellers of assets to folks like us in part because they are such short-term assets of 3 to 6 months. There has been good performance, but capital comes back to you so swiftly. You don’t see large portfolios out there really of any scale kind of like venture lending, for example, it’s very hard to scale that business, because money comes back to you so fast. And then on the consumer side which is the bulk of what we do within NPRC and the team there, you talked about tepid results at a Lending Club, we are very happy with our Lending Club platform results. The remarks that they made this week pertain to other types of assets that are not the assets we hold. We are in their policy too, which is not publicly reported in really more near-prime centric as opposed to lower prime centric. So, we are happy with the performance. Debt investors are happy with the performance. Securitization arrangers are happy with the performance, which is why you saw a securitization in June and why in our prepared remarks I have talked about gearing up for the next securitization as well. And some of the other platforms that we have done sort of legacy ones years ago, we have not been actively deploying new capital or growing those books in any significant fashion for quite a while and we are actually looking at doing a effectively a dividend recap to take capital out of that business and then redeploy it, might deploy it into Lending Club near-prime originations, might deploy it somewhere else within NPRC or take it back to PSEC and deploy it somewhere else entirely. So, that’s all part of the ongoing optimization for the online business. Is that helpful, Chris?

I am sorry I had that muted I guess. Just on the CLO equity valuation, how many instances are there, when the third-party that you use has a valuation that’s higher than the nonbinding indicative bids that you receive in the portfolio?

Yes. I am trying to understand the question, I mean, the valuation which is 100% third-party as you know it speaks as of a certain date. These are highly illiquid Level 3 assets. You don’t really have daily trades in the marketplace so.

If you have let’s say not – if you could receive a nonbinding indicative bid on let’s say a good portion on the portfolio, obviously the third-party valuation firm is coming up with their own valuation, but nonetheless, how many – I am just asking how many times is a valuation that gives you how many times is that higher than what the nonbinding indicative bid is on the book?

I am not sure, Chris. I will say non-binding indicative bids aren’t worth the paper they are written on. Actual close transactions were a lot more meaningful and you don’t have very many data points to look at and what is a highly illiquid part of the marketplace. One piece, I want to address on the valuation front, I know you have had commentary on this as well is when you look at our CLO book and some people compare them to other practitioners in the industry that run RICs and report valuations. And you look at on an aggregate basis, valuation as a percent of cost, what you see actually is that PSECs, CLO structured credit book is in line with or below comps and below by a pretty significant degree. What you also see again this is a 100% third-party. We don’t do valuations around here as the management team, we don’t do the valuations they are done by third-party. What you also see is a significantly below income recognition, which our management team is much more involved in and approved by auditors to the tune of 500 basis points below others in the marketplace. So, we are very secure and confident in our conservative accounting surrounding our structured credit business.

Okay, that’s all for me. Thanks for taking my questions.

Thank you.

There are no additional questions at this time. This concludes our question-and-answer session. I would like to turn the conference over to John Barry for closing remarks.

Okay. Thank you everyone. Have a wonderful afternoon and thank you for joining the call. Bye now.

Thank you.

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