Prospect Capital Corporation (PSEC) Q3 2021 Earnings Report, Transcript and Summary

Good day, and welcome to the Prospect Capital Third Fiscal Quarter Earnings Release and Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, 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, Sarah. Joining me on the call today are my friends, 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 forecasts due to the impact of many factors. We do not undertake to update our forward-looking statements, unless required by law. For additional disclosure, please see our earnings release and our 10-Q 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. Before reviewing the quarterly results, I would like to accentuate the obvious by thanking the multiple teams at Prospect. They helped us produce the numbers that everyone sees this quarter. I can start with Kristin and her accounting team, who worked all weekend to take care of some last minute items, that would otherwise be a thankless task, but I'm thanking Kristin and her team - her large team for that; our lawyers led by Jon Li protect our firm and our shareholders every step of the way; on our investments; on any disagreements we may have with counter parties, fortunately they are rare; our investment professionals from structured credit to aircraft leasing to real estate led by Ted Fowler. These business units have been firing on all 8 cylinders, the last 10 quarters, which is when our NAV was last at this level. And I want to thank all of the people who work at Prospect for making this happen and for their dedication and devotion to the shareholders that trust us. Shareholders, many of whom, have been with us since our initial public offering in 2004. So on behalf of all shareholders, I am thanking all the people that work at Prospect for a job well done. Many of them are shareholders along with me' and people listening to this call, and are benefiting from their hard work financially. So let's turn to the results for the quarter. In the March quarter, our net investment income was $73.4 million, $0.19 per common share, exceeding our distribution rate per common share by $0.01. Our basic net income, attributable to common stockholders was $246 million or $0.64 per common share, as the overall value of our investment portfolio increased for the fourth consecutive quarter due to a combination of positive company-specific and macro factors. Our NAV stood at $9.38 per common share in March, up $0.42 and 5% from the prior quarter, our fourth consecutive quarter with NAV growth. Our NAV per common share is now at the highest level since June 2019. We have outperformed our peers during the past multiple quarters of macro pressure as a direct result of our previous derisking from not chasing leverage as well as other risk management controls. We are staying true to the strategy that has served us well since 1988, controlling and reducing portfolio and balance sheet risk, both to protect the capital entrusted to us and to protect the ability of such capital to generate future earnings for our shareholders. In the March quarter, our net debt to equity ratio was 56.5%, down 1,760 basis points from March 2020 and down 460 basis points from our December quarter, as we continue to run an underleveraged balance sheet, which has been the case for us over multiple quarters. Over the past 3 years, other listed BDCs overall have increased leverage with a typical listed BDC now at over 100% debt to equity or over 40 percentage points higher than for Prospect. Prospect has not increased debt leverage chasing returns, instead electing lower leverage and lower risk at this time in the economic cycle, as money printing and inflation, every investor's enemy, return in force. In May 2020, we moved our minimum 1940 Act regulatory asset coverage to 150% equivalent to 200% debt to equity, which not only increased our cushion, but also gave us flexibility to pursue our recently announced junior capital perpetual preferred equity program, which counts toward '40 Act asset coverage, but which gets significant equity treatment by our rating agencies and which provides significant equity cushion for any leverage. We have no plans to increase our actual drawn debt leverage beyond our historical target of 0.7 to 0.85 debt to equity and we are significantly below such target range. Prospect's balance sheet is highly differentiated from peers with 100% of Prospect's funding coming from unsecured and non-recourse debt since our IPO in 2004. Unsecured debt was 84.3% of Prospect's total debt in March 2021. We are about 28 percentage points higher than around 56% for the typical listed BDC. Our unsecured and diversified funding profile provides us significantly lower risk and significantly more investment strategy and balance sheet flexibility than many of our BDC peers enjoy. On the cash shareholder distribution front, we are pleased to report the Board's declaration of continued steady monthly distribution. We are announcing monthly cash common shareholder distributions of $0.06 per share for each of May, June, July and August. These 4 months represent the 45th, 46th, 47th and 48th consecutive $0.06 per share dividend, monthly dividend, meaning, we have now reached the 4-year mark for stable monthly cash shareholder distributions. Consistent with past practice, we plan on our next set of shareholder distributions in August. Our goal over the long term is to maintain and ideally grow this steady monthly cash shareholder distribution, as we seek to provide low volatility income stability to our shareholders amidst a macro market backdrop that delivers greater volatility elsewhere. Since our IPO, nearly 17 years ago, through our August 2021 distribution at the current share count, we will have paid out $18.84 per common share to original shareholders, aggregating approximately $3.4 billion in cumulative distribution to all common shareholders. Since October 2017, our net investment income per common share has aggregated $2.74, while our shareholder distributions per share have aggregated $2.52, resulting in our net investment income exceeding distributions during this period by $0.22 per share. Our net investment income covered distributions in the June 2020 fiscal year and have exceeded distributions in the 2021 fiscal year-to-date by $0.02 per share. We are also announcing more preferred shareholder distributions, following the launch of our $1 billion 5.5% preferred program. We've raised over $80 million in our preferred stock program to-date from institutions, family offices, registered investment advisors, broker-dealers and other savvy investors, including the recent addition of a top 5 independent broker-dealer system. Looking forward, we are currently focused on multiple initiatives to enhance our net investment income and NAV and return on investment in an accretive fashion, including first, our recently announced $1 billion perpetual preferred stock equity program; #2, greater utilization of our cost-efficient revolving credit facility, which provides us an incremental cost of capital of approximately 1.46% at today's one month Libor; #3, retirement of higher cost liabilities, including multiple recent successful tender offers and repurchases; #4, issuing lower cost notes, including recent 5-year senior unsecured notes with coupons of approximately 3% to 3.7%; and #5, increased origination in senior secured debt and selected equity investments to deliver targeted risk-adjusted yields and total returns as we deploy available capital from our current underleveraged balance sheet. We believe there is no greater alignment between management and shareholders than for management to purchase in the market a significant amount of stock, particularly when management has purchased every share on the same basis as other shareholders in the open market, as we have. Prospect management is the largest shareholder in Prospect and has never sold a share. Senior management and employee insider ownership is currently approximately 28% of shares outstanding, representing over $1 billion of our net asset value. We are trying to think of a management team at any other company that eats its own cooking to the extent we have. Thank you. I'll now turn the call over to Grier.

Thank you, John. Our scale platform with over 6.4 billion of assets and undrawn credit continues to deliver solid performance in the current challenging environment. Our experienced team consists of around 100 professional, representing one of the largest middle market investment groups in the industry. With our scale, longevity, experience and deep bench, we continue to focus on a diversified investment strategy that spans third-party private equity sponsor-related lending, direct non-sponsor lending, Prospect-sponsored operating and financial buyouts, structured credit and real estate yield investing. Consistent with past cycles, we expect during the next downturn to see an increase in secondary opportunities coupled with wider spread primary opportunities with a pullback from other investment groups, particularly highly leveraged ones. This diversity allows us to source a broad range in high volume of opportunity, 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 March 2021, our portfolio at fair value comprised 51.8% secured first lien, up 4.5% from December, 15.2% other senior secured debt, 12.8% subordinated structured notes with underlying secured first lien collateral, 0.1% unsecured and other debt and 20% equity investment, resulting in a stable 79.8% of our investments being assets with underlying secured debt benefiting from borrower pledge collateral. Prospect's approach is one that generates attractive risk adjusted yield and our performing interest-bearing investments were generating an annualized yield of 11.8% as of March. We achieved this increase despite a headwind for the past year decline in Libor, though we expect reasonable stability now due to our Libor floors. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generate distribution. We've continued to prioritize 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 March, we held 123 portfolio companies, up 1 from the prior quarter with a fair value of $5.88 billion, an increase of $258 million from the prior quarter. We also continue to invest in a diversified fashion across many different portfolio company industries with a preference for avoiding cyclicality and with no significant industry concentration. The largest is 16.7%. As of March, our asset concentration in the energy industry stood at 1.3%, our concentration in the hotel, restaurant and leisure sector stood at 0.4% and our concentration in the retail industry stood at 0%. Non-accruals, as a percentage of total assets, stood at approximately 0.7% in March 2021, flat from the prior quarter. Our weighted average middle-market portfolio net leverage stood at 5.05x EBITDA, substantially below our reporting peers. Our weighted average EBITDA per portfolio company stood at $82 million in March 2021. Originations in the March quarter aggregated $258 million. We also experienced $182 million of repayments and exits as a validation of our capital preservation objective and sell down of larger credit exposures, resulting in net originations of $76 million. During the March quarter, our originations comprised 77.2% middle-market lending, 17.8% real estate and 5% middle-market lending and buyout. To-date, we've deployed significant capital in the real estate arena through our private REIT strategy, largely focused on multi-family workforce stabilized yield acquisitions with attractive 10-year plus financing. NPRC, our private REIT, as real estate properties that have benefited over the last several years from rising rents, strong occupancies, high returning value-added renovation programs and attractive financing recapitalization, resulting in an increase in cash yields as a validation of this income growth business alongside our corporate credit businesses. NPRC, as of March, has exited completely its 34 properties at an average IRR of 23.4%, with an objective to re-deploy capital into new property acquisitions, including with repeat property manager relationships. We continue to monitor our rent collections, which are holding up well in the current environment. Our structured credit business has delivered attractive cash yields, demonstrating the benefits of pursuing majority stakes, working with world-class management team, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities. As of March, we held $751 million across 39 non-recourse subordinated structured notes investment. These underlying structured credit portfolios comprised around 1,700 loans and a total asset base of around $17 billion. As of March, the structured credit portfolio experienced a trailing 12-month default rate of 171 basis points, down 35 basis points from the prior quarter and representing 144 basis points less than the broadly syndicated market default rate of 315 basis points. In the March quarter, this portfolio generated an annualized cash yield of 18.6% and GAAP yield of 15.2%. As of March, our subordinated structured credit portfolio has generated $1.29 billion in cumulative cash distributions to us, representing around 92% of our original investment. Through March, we've also exited 9 investments, totaling $263 million with an average realized IRR of 16.7% and cash on cash multiple of 1.5x. 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 and 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've completed 28 refinancings and resets since December 2017. So far in the current June 2021 quarter, we booked $67 million in originations and experienced $85 million of repayments for $18 million of net repayment. Originations have comprised 91.9% middle-market lending and 8% subordinated structured notes. Thank you. I'll now turn the call over to Kristin. Kristin?

Thank you, Grier. We believe our prudent leverage, diversified access to match book funding, substantial majority of unencumbered assets weighting toward unsecured fixed rate debt, avoidance of unfunded asset commitments and lack of near-term maturities, 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 22 years into the future. To-date, we have 0 debt maturing until July 2022. Our total unfunded eligible commitments to non-control portfolio companies totals approximately $24 million or 0.4% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stand at approximately $814 million. 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 first. In 2020, we've also added our programmatic perpetual preferred issuance to that list 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 the balance sheet. As of March 2021, we held approximately $4.4 billion of our assets as unencumbered assets, representing approximately 73% of our portfolio. The remaining assets are pledged to Prospect capital funding, where in April 2021, we completed an upsizing and extension of our revolver to a refreshed 5-year maturity. We currently have $1.0825 billion of commitments from 32 banks, an increase of 2 lenders from before and demonstrating strong support of our Company from the lender community. The facility revolves until April 2025, followed by a year of amortization with interest distributions continuing to be allowed to us. Our drawn pricing is now Libor plus 2.05%, a decrease of 15 basis points from before. Our undrawn pricing between 35% and 60% utilization has been reduced by 30 basis points. We also now have an improvement in our borrowing base due to a change in concentration baskets, which we estimate has increased our borrowing base by approximately $150 million. Of our floating rate assets, 91.2% have Libor floors with a weighted average floor of 1.62%. Outside of our revolver and benefiting from our unencumbered assets, we have issued at Prospect Capital Corporation, including in the past few 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 negative rating from S&P, an investment grade Baa3 rating from Moody's, an investment grade BBB negative rating from Kroll, an investment grade BBB rating from Egan-Jones and an investment grade BBB low rating from DBRS. We recently received the latter investment grade rating, taking us to 5 investment grade ratings, more than any other company in our industry. We have now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration of 22 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 March 2021 quarter, we completed successful tender offerings, repayments and repurchases, retiring around $52 million of our 2022 notes, $5 million of our 2023 Notes, $8 million of our 6.375% 2024 notes, and $234 million of our 2024 and $45 million of our 2025 notes. In the current June quarter through tender offerings, we have retired $1 million of our 2023 notes. In the March 2021 quarter, we issued $400 million in unsecured debt, maturing in January 2026 with a coupon of 3.7%. We have continued to substitute more expensive term debt with significantly lower cost revolving credit with an incremental 1.46% cost and our newly issued 2026 notes. We also have continued with our weekly programmatic InterNotes issuance on an efficient funding basis. To-date, we have raised approximately $80 million in aggregate issuance of our perpetual preferred stock. We now have 7 separate unsecured debt issuances, aggregating $1.2 billion, not including our program notes with maturities extending until June 2029. As of March 2021, we had $673 million of program notes outstanding with staggered maturities through October 2043. We have added a shareholder liability benefit to our dividend reinvestment plan or DRIP, that allows for a 5% discount to the market price for DRIP participants. As many brokerage firms either do not make DRIPs automatic or they have their own synthetic DRIPs with no such 5% discount benefit, we encourage any shareholder interested in DRIP participation to contact your broker. Make sure to specify you wish to participate in the Prospect Capital Corporation DRIP plan through DTC at a 5% discount and obtain confirmation of the same from your broker. Our preferred holders can also elect to DRIP at a price per share of $25. Now, I'll turn the call back over to John.

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

[Operator Instructions] Our first question comes from Robert Dodd with Raymond James.

Congrats on the quarter. A couple of questions about specific assets, if I can. First on the First Tower, it was one of your bigger line-ups this quarter, not a lot of disclosure in the Q about why - I mean, just financial performance was better. Can you give us any metrics there on revenue growth, receivables outstanding, any kind of metrics to give us some information on how much the financial improvement was better, et cetera?

Yes, Grier can do that. Go ahead, Grier.

Robert, so to describe the boost in value for First Tower, which was about $48 million for our position as - in significant part due to underlying performance and in a partial part due to improvement in metrics and values for comparable companies, including public comps that help to drive the valuation. These types of companies are - have been trading quite well in the March quarter. From a fundamental standpoint, which, of course, is what we focus very hard on, we've seen an improvement in multiple areas. We've seen improvement in same-store sale, we've seen an improvement in charge-offs, really in all the states in which First Tower operates. And we've also received a benefit in our financing costs, which is our floating rate with a strong and supportive bank group that has been with the business for years - really decades and know the company well and underwrite. So, with Libor at a very low level - our financing cost have been low for the company as well. Obviously, the macro backdrop is constructive with strong consumer wallet helped in significant part by fiscal spending, which has the important driver in consumer credit across the board. But we credit the management team led by Frank Lee, whose family founded the company decades to go. Frank is a wonderful business person, leader and 20% equity holder and has done a strong job along with the rest of the management team in sustaining and increasing improving performance, including in states where First Tower has expanded in recent years. And whenever you expand into a new geography, there's always a micro learning curve associated with the particular nuances of that area and individual management teams at the branch level that need to be managed. So we're very happy with the across-the-board performance, we've now been an 80% owner of this business and lenders to the company as well for almost 10 years, about 9 years and it's been a strong long-term of hold cash produced there and highly tax efficient as well, tax partnership, no taxation downstairs and tax rate compliance of no taxation upstairs. So very pleased with First Tower.

Got it, thank you. I mean, just on that - I mean, given the valuation, I mean, it's a very sizable asset on your books, under what - I mean, I know good income contributed as well. Very good. Under what conditions would you consider selling that asset and re-deploying the capital into a more diversified pool maybe other than one large single asset?

Well, we view it as a diverse granular pool actually not a large singular asset. There are hundreds of thousands of loans that underpin that book, so it's arguably more diversified than a corporate credit book with 100 to 200 names, and geographically diversified as well. So we view it in a look-through diversified fashion. We, from a long-term hold standpoint, evaluate this asset as we would any other in the book. For example, in our real estate business, we do this regularly where we update, on a quarterly basis, NPVs of each asset. Should we hold this asset? Should we divest it with the foregone IRR from divesting it? Should we optimize the financing or in some other fashion with the NPV maximizing strategy? And where can we profitably redeploy the proceeds? It would take a lot in order to sell this asset, because it is so wonderfully tax efficient for us, we are the lowest cost of capital, most tax efficient owner of this business. We've already become a standalone public company, which certainly is of scale and stature to do with the north of $100 million EBITDA business. It would be a corporate taxpayer and perhaps, corporate tax rates are going up, we'll see, but there's certainly a non-0 out there. There is 0 for us taxed as a flow-through partnership. So that would be a very challenging endeavor, because the bar of high volume public - that would super impose a higher cost structure than where we hold the business today. So we're happy with the business, we haven't focused on hyper growth, we focused on proper underwriting, really using the theme, tried and true fundamental old fashion values of consumer credit underwriting that have underpinned this A loan instalment lender, that's a bit higher up on the quality spectrum than others in the space. And do not have any immediate plan to exit the position.

Okay, got it. Thank you for that. On - one - on the - REIT, I mean, in the Q, one of the reasons for the mark up in the REIT was obviously cap rate compression. John, in your prepared remarks, you talked about, obviously enough of the potential for rising inflation, I wouldn't necessarily think that would impact cap rates in the short run, but what's your view of the potential for longer-term inflation and how would that influence cap rate at the REIT - under all REIT parallels?

Okay. Well, Robert, I'm glad we give Grier rest for a second. Just before I do, just more on First Tower. It's rare that we can find a management team and buy a business run by a management team that is experienced and expertise as Frank Lee's team, Darryl Schroeder, Jody Macon. And frankly, Frank has been running that business with his team for decades through thick and thin. So knowing how hard it is to find great managers, I would be very slow to vote to sell First Tower and attempt to deploy the proceeds into another business. What we wouldn't be more likely to do is hopefully find another great manager like Frank Lee and bag that manager and build that business. Under Frank's tutelage, First Tower has grown significantly. Our internal team, Denis, Aderly and Edward have helped Frank do that by optimizing the capital structure, helping to analyze additional acquisitions, horizontal extensions. And so, we have a good situation with our internal team and with the external team. And so, Robert, I - if you find a company that we should buy, we'd love to buy it, but I don't think we are going to need to sell First Tower as I think you know, we are significantly underlevered, at least compared to other BDCs. So we have a war chest of capital that we're just sitting on and waiting for the - now, I'm getting to your question, right? It's like Alice's Restaurant, I'll finally get there. We see - I mean, I think you put your common sense head on and ask yourself the U.S. government spend how many trillions? Is it $6 trillion in less than a year, I was just mailing checks to people and expect that there would not be inflation. Of course, there will be inflation and we're seeing it everywhere, lumber, commodities, housing prices, bitcoin. So we are sitting on a war chest, because we believe this will be very similar to what happened during the Carters years and the Fed will have to chase the inflation. Raising interest rates won't be helpful to anybody, but our job as stewards of our shareholders' capital is to see reality for what it is, not for what people want to tell us it is. And yes, investors' worst enemy is at the door, inflation. Because what happens is, first, you are being taxed on returns that are - that may not even be positive on a real basis. Fortunately, investors in our company are receiving the high, real as well as nominal returns, but investors in some of these tech companies are going to see inflation and higher interest rates significantly erode the outyear value as discount rates compound up and diminish the value of the gold at the end of the rainbow 10 years from now. So the way we see it, our war chest of capital, our low leverage, our expertise and dedicated, really devoted origination team is ready for what comes next. We believe that there will be companies in distress as there have been in the past and that we will be able to purchase those companies at distressed prices. So that's why we've been keeping our leverage well, even though some people would argue, if you can borrow at 1.76% and reinvest at 10%, why aren't you doing more of that? Well, if you read the book Built to Last, you will see that if you want to build a company to last, you remain disciplined through all cycles and get ready for the next one. So that's why I added to my remarks, my concern about upcoming inflation and the need for really all investors to be ready for it. Is your view different, Robert?

I wouldn't say it's substantially different, but you're the one running the company. So I just wanted to get your opinion on that point.

I just have to evaluate it, not run it.

Just - so you had asked about real estate, Robert. And real estate is a classic inflation hedge, especially multi-family and why is that? Well, because one can reprice the rent frequently, because the leases are 1-year typical duration. At the same time, financing costs are locked in for the long term and we have essentially almost entirely fixed rate long term financed book. So your financing costs and debt service payments are fixed, while rents go up in an inflationary environment and net operating income goes up. It is possible there is a give back to your question about cap rates if the Fed respond as inflation fighting in terms of increasing short term rate to the extent that increases a typical benchmark like a 10-year treasury to which financing costs would often be pegged. And it is possible that there could be some cap rate increases that occur as a result, but the net operating income will surely be growing in that inflationary environment. So, I like that those are significant offsetting trends, maybe NOI growth is actually greater because you get an investor rotation into the sector fleeing fixed income in other areas that are having issues. So you may not have the change in cap rates at all and you get the NOI boost, so the best of both worlds. So we view that as the leading light and really bright star in the portfolio that differentiates us substantially from our peers in an inflationary environment or potential for substantial increase and inflation due to the Fed's printing of money and are very, very happy with the performance of our real estate book. It also acts as a significant diversification benefit relative to the rest of the book, low correlation, dampens volatility, efficient frontier, attractive addition to the investment portfolio construction. So, we're quite pleased with that business and we continue to make new investments and we continue to exit investments selectively, utilizing that quarterly NPV maximization, disciplined capital allocation methodology that I articulated previously.

So Robert, as you remember, in the 1970s and early '80s, the real estate investors were the people that survived the huge inflation then with more of their capital than anyone else. So we do regard our large multi-family book as an anchor to win with. Okay. Well, thanks everyone. Have a wonderful afternoon. Bye now.

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