Prospect Capital Corporation (PSEC) Q1 2020 Earnings Report, Transcript and Summary

Good day 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 that 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, Ailie. Joining me on the call this morning are Grier Eliasek, our President and Chief Operating Officer; and Kristin Van Dask, our Chief Financial Officer. Kristin?

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 and our 10-K filed previously and available on the Investor Relations tab on our website, prospectstreet.com. Now, I’ll turn the call back over to John.

Thank you, Kristin. For the September 2019 quarter, our net investment income or NII was $71.1 million or $0.19 per share, the same as the prior quarter and again, exceeding our current dividend rate of $0.18 per share. Our ratio of NII to distributions was 107%. In the September 2019 quarter, our net debt-to-equity ratio was 66.3%, down 3.7% from the prior quarter. As we continue to maintain a prudent leverage profile and cautious approach to capital deployment in the current environment. Our net income for the quarter was $18.1 million or $0.05 per share, a decrease of $0.06 from the last quarter, primarily due to a decrease in portfolio evaluations during the September 2019 quarter. We have multiple disciplined strategies in place with a goal of enhancing our future risk adjusted income. On the asset management side, we plan on executing on our pipeline of new originations, improving cash flows in our structured credit portfolio, including through extensions, refinancings, and calls, enhancing NPRCs largely multifamily real estate portfolio including through realizations, refinancings and supplemental dividend recapitalizations, and increasing results that control investments, including improving operating performance, closing accretive bolt-on acquisitions and monetizing at attractive exit points. On the liability management side, we plan on protecting against maturity risk through continued liability, laddering issuance of diverse instruments to a diverse investor base while managing both our cost of capital and leverage profile. We are announcing monthly cash distributions to shareholders of $0.06 per share for each of November, December, and January, representing 138th consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in February 2020. Since our IPO through our February 2020 distribution at our current share count, we will have paid out $17.70 per share to original shareholders, aggregating approximately $3 billion in cumulative distribution to all shareholders. Our NAV stood at $8.87 per share in September down $0.14 from the prior quarter. Our balance sheet, as of September 2019, consisted of 86.9% floating rate assets and 95.2% fixed rate liabilities. In recent months, we’ve trimmed our cost of term debt issuance commensurate with reductions in treasuries, while also retiring more expensive upcoming maturities. Our percentage of total investment income from interest income was 90.2% in the September 2019 quarter, a decrease of 2% from the prior quarter. We believe there is no greater alignment between management and shareholders then for management to purchase a significant amount of stock, particularly when management has purchased stock only on the same basis as other shareholders in the open market. Profit Management is the largest shareholder in Prospect and has never sold a single share. Management and affiliates on a combined basis have purchased at costs approximately $400 million of stock in Prospect. Our management team has been in the investment business for decades. With experience handling both challenges and opportunities provided by dynamic economic and interest rate cycles. We have learned, where there is more productive to reduce risk than to reach for yield and 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, including through our recent reduction in leverage during the September 2019 quarter. Thank you. I will now turn the call over to Grier.

Thank you, 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 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 2019, our controlled investments at fair value stood at 44% of our portfolio, up 0.2% from the prior quarter. 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 2019, our portfolio at fair value comprised 43.3% secured first lien, 23.1% secured second lien, 15% subordinated structured notes with underlying secured first lien collateral, 1% rated secured structured notes, 0.8% unsecured debt and 16.8% equity investments, resulting in 82.4% 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. In our performing interest-bearing investments, we’re generating an annualized yield of 12.7% as of September 2019, down 0.4% from the prior quarter. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generate distributions. We’ve continued to prioritize senior unsecured 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 2019, we held 125 portfolio companies, down 10 from the prior quarter due to repayments and exits with a fair value of $5.45 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 15.7%. As of September 2019, 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 2.4% in September 2019, a decrease of 0.5% from the prior quarter. Our weighted average portfolio net leverage stood at 4.69 times EBITDA, up 0.02 from the prior quarter. Our weighted average EBITDA per portfolio company, stood at $62.0 million in September 2019, up from $60.7 million in the prior quarter. Originations in September 2019 quarter aggregated $95 million. We also experienced $245 million of repayments and exits as a validation of our capital preservation objective and sell-down of larger credit exposures, resulting in net repayments of $151 million. During the September 2019 quarter, our originations comprised 79% non-agented debt, including early-look anchoring and club investments; 8% corporate yield buyouts, 7% rated secured structured notes and 6% agented sponsor debt. To date, we’ve deployed significant capital in the real estate arena through our private REIT strategy, largely focused on multifamily, workforce, stabilized yield acquisitions with attractive 10-year-plus financing. NPRC, our private REIT, has real estate properties that have benefited from rising rents, strong occupancies, high-returning value-added renovation programs and attractive financing recapitalizations, resulting in an increase in cash yields as the validation of this income growth business alongside our corporate credit businesses. NPRC has exited completely 21 properties with an objective to redeploy capital into new property acquisitions, including with repeat property manager relationships. We expect our exits to continue and have identified multiple additional properties for potential exit in calendar years 2019, 2020 and beyond. Our structured credit business has delivered attractive cash yields, 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 2019, we held $818 million across 39 non-recourse subordinated structured notes investments. These underlying structured credit portfolios comprised around 1,800 loans and a total asset base of over $18 billion. As of September 2019, the structured credit portfolio experienced a trailing 12-month default rate of 40 basis points, representing 89 basis points less than the broadly-syndicated market default rate of 129 basis points. In the September quarter, this portfolio generated an annualized GAAP yield of 15.5%. As of September 2019, our subordinated structured credit portfolio has generated $1.1 billion in cumulative cash distributions to us, representing around 81% of our original investment. Through September 2019, we’ve also exited nine investments totaling $263 million with an average realized IRR of 16.7% and cash-on-cash multiple of 1.5 times. Our subordinated 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 receive 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 or reset the investment period to enhance value. We have completed 26 refis and resets since September –since December rather 2017. So far in the current December quarter, we’ve booked $19 million in originations and received repayments of $23 million, resulting in net repayments of $4 million. Our originations have comprised 53% real estate, 25% non-agented debt, and 22% agented sponsor debt. Thank you. I’ll now turn the call over to Kristin.

Thanks, Grier. Thanks, Grier. We believe our prudent leverage, diversified access to matched-book funding, substantial majority of unencumbered assets and weighting toward 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 liabilities extending 24 years into the future. We are 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 under a bond ATM, 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 towards construction of the right-hand side of our balance sheet. As of September 2019, we held approximately $4.02 billion of our assets as unencumbered assets, representing approximately 72% of our portfolio. The remaining assets are pledged to Prospect Capital funding, where in September, we completed an extension of our revolver to a refreshed five-year maturity. We currently have $1.0775 billion of commitments from 30 banks with a $1.5 billion total size accordion feature at our option. the facility revolves until September 2023, followed by a year of amortization with interest distributions continuing to be allowed to us. outside of our revolver and benefiting from our unencumbered assets, we’ve issued at Prospect Capital corporation, including in the past two years, 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, an investment-grade BBB rating from Egan-Jones, an investment-grade BBB- rating from S&P and an investment-grade Baa3 rating from Moody’s, so a total of four investment-grade ratings. We have now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 24 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. In the September 2019 quarter, we repurchased $47 million of our April 2020 notes as well as $144 million of our program notes. We also continued our weekly programmatic InterNotes issuance. 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 had demonstrated in the first half of calendar year 2016 during market volatility. We now have eight separate unsecured debt issuances aggregating $1.5 billion, not including our program notes, with maturities extending to June 2029. As of September 2019, we had $657 million of program notes outstanding with staggered maturities through October 2043. Now, I'll turn the call back over to John.

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

[Operator Instructions] Our first question comes from Matt Tjaden with Raymond James.

Hey, Matt.

Hi, all. I’m on the line with – for Robert, good morning.

Dr. Robert, give him our best.

I definitely will. So, first question in a couple of leading off of it will kind of be related to LIBOR. So, last quarter, I know we kind of talked about a decreasing rate environment kind of some signal softening economic conditions. Have you all been seeing any of that in your underlying portfolio companies?

Well, would you want to take that, Grier?

Sure. Well look, I’m not sure we want to wax poetic about macroeconomic conditions that obviously LIBOR went down, because of fed cutting based on the economic weakness and more in the manufacturing and selected part of the corporate sector and the consumer continues to be very strong. And anything that’s consumer-centric and outlook, for example, our consumer finance businesses are putting up some very nice numbers today. So, it’s uneven, I would say like the rest of the economy areas of manufacturing and industrial and energy are challenge, because of the terrorist situation. But we have very little exposure to those segments. Today, energy is less than 3% of our book and is really a pittance exposure compared to where it was many, many years ago in our book. So, we’re not really seeing a dramatic slowdown, but we are concerned, given the length of the bull market that we’ve had to date. We’re also concerned, because of structures we’ve seen occurring with loans out there, given the significant influx of capital, especially on the institutional side with significant allocations to private debt in the last three to five years that money has to go somewhere and it’s going into to loser structures without covenants at a higher leverage and most concerning with very aggressive adjustments. So, a big reason why our originations were down in the prior quarter on the new capital deployment side as we’ve been saying no to so many deals. In part, it’s the underwriting aspects and we have your full time people that do nothing but basically say no to two adjustments on what comes pushed at us from big six accounting firms in their queue of ease. And in part, it’s because of how we run our underwriting models, where base cases always assume a recession occurring within the investment horizon. Say a five year, your first lien senior secured loan and on the earlier side of that five years now with our corporate expectation and underwriting. So, when you assume cyclicality, you’re not saying no to a lot of deals that others say yes to and that’s a challenge. What’s also challenges; we have significantly reduced our underwriting hold size from risk management standpoint. So that means more deals to deploy similar dollars compared to before. We think that’s a prudent risk management approach as well. I’m encouraged by what we’re seeing in the pipeline right now going forward, but it has meant net repayments in the last couple of quarters.

Matt, this is John. I liked the question so much. I just mentally reviewed all 125 positions that we have. And I think the common theme at least for me is it each one depends far more on the abilities of management to run their companies efficiently to take advantage of opportunities. And that’s how the middle market is, where typically these smaller companies have a very large opportunity set. And if they execute on that, they will be less subject to macro developments. So that’s an opportunity for us. But it’s also a challenge, because we do have to find and back the very best managers, which is, trust me, we’re busy doing that. Thank you.

That’s very helpful. And then kind of a follow-up question related to that, through the second half of 2019 as it relates to originations, are you seeing any spread widening?

A little bit – you say through the second half through today, there’s a little bit of a response. You’re not quite symmetric with the spread tightening that occurred with an increase in LIBOR. It’s not quite an asymmetric response with a spread widening with a decrease in LIBOR. And I think the reason for that is that influx of capital that I mentioned before that has to have a place to go, at least in the middle market and especially in the middle market, where capital can’t disappear from the scene quite so quickly as it can on the larger side and syndicated market, where fund flows can reverse streams and where capital can actually exit. And then you have essentially forced selling through redemptions that can cause a gap out in spread. So, we actually see that more on the larger side of things and we cover both bases directly and indirectly through our structured credit business. So, in the middle market a little bit, I would say we’re spending a lot more time on lower middle market and smaller credit situations than before. In part, it’s because of what I mentioned before about reducing hold size in part is because of our desire to have covenants in agented deals. And in part it’s because of lessened competition and improved spread. So, it really depends on the segment. I would say that that middle portion in between the lower middle market and broadly syndicated is stubbornly not showing an increase in spreads that you might hope to see at this point of the fed cycle.

Okay. And then kind of a shift away from rates, specifically on InterDent. So, a $60 million mark down on the Term Loan C, just given the large relative size of the investment, any guidance you all are willing to provide on the asset.

Well, just to give a little bit of color on that with InterDent, a dental services company, highly recurring revenue business that the fundamental demand is not in question, given it’s basically a teeth cleaning and recurring service. One part of the business is a fee for services, largely private pay business. And the other is a Medicaid-centric business based in Oregon. There was a downtick in volumes in Oregon, because of contracting activity in the last year. Now, there’s a new set of contracting activity occurring. We’re cautiously optimistic. We’re going to pick up some portions. It’s not clear how much of the lost volumes. The business has also been focused on rightsizing its cost structure. There have been some labor cost increases because of the tightening employment market especially within healthcare and the dental part of the healthcare. So, the business is adjusting to that as well. I’d say, we’re cautiously optimistic about seeing improved performance as we head into 2020.

Great. And then kind of similar to that question, $20 million mark down about on the equity of Valley Electric, any guidances to that asset?

Yes. that’s really more of – less to do with how the business is performing. The company is doing terrifically well, recall this is a business that’s an electrical infrastructure focused services company in the Pacific Northwest, largely in Washington State and benefiting from the technology boom of that state that used to be driven by Microsoft years ago and it’s still a major infrastructure employer, but also of course, Amazon and many other technology-based companies. So, the Seattle area and other parts of Washington State are doing quite well, growing infrastructure in the corporate side, which translates into the governmental side, industrial healthcare, et cetera, corporate office side, real estate, all of which Valley benefits from. So, the company’s doing well, there’s basically a change in valuation inputs that get refreshed every quarter based on comps, based on comparable trading multiples, M&A multiples et cetera. So, you saw basically an adjustment there based on inputs. But we’re quite pleased with the company and how the management team has been performing there.

Okay. Well, thanks for all. That is all I had.

Thank you.

Thank you, Matt.

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

Well, I could wax-poetic, but I bet everybody wants to get to lunch. So, thank you very much. Bye now.

Thank you all.

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