Prospect Capital Corp

NASDAQ:PSEC

Earnings Call Transcript 2019-Q4

[Operator]

Good day and welcome to the Prospect Capital 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 that this event is being recorded.

I would now like to turn the conference over to John Barry, Chairman and CEO. Please go ahead, sir.

[John Barry, Chairman and CEO]

Thank you, Chuck. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Kristin Van Dask, our Chief Financial Officer.

Kristin?

[Kristin Van Dask, Chief Financial Officer]

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.

[John Barry, Chairman and CEO]

Thank you, Kristin. For the June 2019 quarter, our net investment income or NII is $69.6 million or $0.19 per share, down $0.02 from the prior quarter and exceeding our current dividend rate of $0.18 per share by $0.01. Our ratio of NII to distributions is 105%.

In the June 2019 quarter, our net debt to equity ratio is 70%, up 0.9% from the prior quarter. Our net income for the quarter is $89.2 million [Later changed by the Company to $38.9 million] or $0.24 [Later changed by the Company to $0.11] per share, an increase of $0.42 [Later changed by the Company to $0.24] from the prior quarter, primarily due to realized and unrealized gains from our portfolio. We are announcing monthly cash distributions to shareholders of $0.06 per share for each of September and October, representing 135 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in November.

Since our IPO over 15 years ago, through our October 2019 distribution at our current share count, we would have paid out $17.52 per share to original shareholders, aggregating approximately $3 billion in cumulative distributions to all shareholders. Our NAV stood at $9.01 per share in June, down $0.07 from the prior quarter.

Our balance sheet as of June 2019 consists of 87.4% floating rate interest earning assets and 93% fixed rate liabilities. In recent weeks, we've trimmed our cost of term debt issuance, commensurate with reductions in treasuries.

Our percentage of total investment income from interest income is 92.2% in the June 2019 quarter, an increase of 1.6% from the prior quarter.

I'll now turn the call over to Grier.

[Grier Eliasek, President and Chief Operating Officer]

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, which represents 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 2019, our controlled investments at fair value stood at 43.8% of our portfolio, up 1.8% from the prior quarter. This diversity allows us to source a broad range in 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 the 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 June, our portfolio at fair value comprised 43.9% secured first lien, 23.5% secured second lien, 15.1% subordinated structured notes with underlying secured first lien collateral, 0.8% rated secured structured notes, 0.6% unsecured debt and 16.1% equity investments, resulting in 83% 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 performing interest bearing investments we're generating, an annualized yield of 13.1% as of June, up 0.3% 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 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 June, we held 135 portfolio companies, down 2 from the prior quarter with a fair value of 5.65 billion. We also continue to invest in a diversified fashion across many different portfolio company industries, with no significant industry concentration. The largest is 14.6%.

As of June, our asset concentration in the energy industries 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 2.9% in June, down 0.4% from the prior quarter.

Our weighted average portfolio net leverage stood at 4.67 times EBITDA, up 0.1 from the prior quarter, after four straight quarterly decreases. Our weighted average EBITDA per portfolio company stood at 60.7 million in June, up from 59.8 million in the prior quarter. Originations in June aggregated 188 million. We also experienced 213 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 25 million.

During the June quarter, our originations comprised 79% non-agented debt, including early look anchoring and club investments, 19% aided and sponsored debt and 2% in corporate yield buyouts. To date we've made multiple investments 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 a real estate portfolio that has benefited from rising rents, solid occupancies, high returning value added renovation programs and attractive financing recapitalizations, resulting in an increase in cash yield as a validation of this income growth business, alongside our corporate credit businesses. NPRC has exited completely over a dozen 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 year 2019 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 June, we held $851 million across 43 nonrecourse subordinated structured notes investments. These underlying structured credit portfolios comprise around 1,800 loans, and a total asset base of over $18 billion. As of June, the structured credit portfolio experienced a trailing 12-month default rate of 39 basis points, 95 basis points less than the broadly syndicated market default rate of 134 basis points. And an increase in our outperformance of 31 basis points.

In the June quarter, this portfolio generated an annualized GAAP yield of 15.6%. As of June, our subordinated structure credit portfolio has generated $1.3 billion in cumulative cash distributions to us, representing around 85% of our original investment. Through June, we've also exited nine investments totaling $263 million, with an average realized IRR of 16.8% and cash and cash multiple of 1.49 times. Our subordinated structured credit portfolio consists entirely a 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 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 and exchange for better terms from debt investors in the deal and extend or reset the investment period to enhance value. We've completed 23 refis and resets since December 2017.

So far in the current September 2019 quarter, we've booked 33 million originations and received repayments of $169 million resulting in net repayments of $135 million. Our originations have comprised 74% non-agented debt and 26% agented sponsor debt.

Thank you. I'll now turn the call over to Kristin.

[Kristin Van Dask, Chief Financial Officer]

Thanks, Grier. We believe our prudent leverage, diversified access to matchbook funding, substantial majority of unencumbered assets and waiting towards unsecured fixed rate debt, demonstrates 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, developed a notes program, issue under a bond ATM, acquire another BDC and many other lists of first.

Shareholders and unsecured creditor 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 June 2019, we held approximately 4.12 billion of our assets as unencumbered assets, representing approximately 71% of our portfolio. The remaining assets are pledged to Prospects Capital funding, where in the past year we completed an extension of our revolver by 5.7 years, reducing the interest rate on drawn amounts to one month LIBOR plus 220 basis points.

We currently have 1.1325 billion of commitments from 30 banks with a 1.5 billion total size accordion feature at our option. The facility revolves until March 2022, followed by two years 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 and investment-grade BBB negative rating from S&P and an investment-grade BAA3 rating from Moody's. So a total of four investment-grade ratings.

We've now tapped the unsecured trend debt market on multiple occasions to ladder our maturities and to extend our liability duration out 24 years. Our debt maturities extend to 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 June 2019 quarter, we repurchased 25 million of our April 2020 notes, as well as 156 million of our program notes. We also issued 4 million of baby bonds through our ATM program, and continued our weekly Internet program with 112 million of 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 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 June 2019, we had 708 million of program notes outstanding with staggered maturities through October 2043.

Now I'll turn the call back over to John.

[John Barry, Chairman and CEO]

Thank you. We can now answer any questions.

[Operator]

We will now begin the question-and-answer session. [Operator Instructions]. The first question will come from Robert Dodd with Raymond James. Please go ahead.

[Robert Dodd, Raymond James]

Just looking at the current rate outlook environment, obviously you've got a primarily floating rate book and fixed rate liabilities. So if the LIBOR curve is correct currently, and we drop from what was something like 2.5 in the June quarter to something more like 1.5 by the end of next year, what plans can you put into place to kind of mitigate that impact? Obviously, one of the options is leveling up. And can you give us any color on how much of your liability structure still has a one-to-one covenant embedded in it versus just fully at compliance and then what you can do on the asset side as well?

[John Barry, Chairman and CEO]

Sure. Go ahead, Grier.

[Grier Eliasek, President and Chief Operating Officer]

Okay. Thank you, Robert, for your question. Obviously, an environment in which LIBOR is decreasing can also signal concerns on an economic basis. So, it starts with a principal protection and credit protection from an underwriting standpoint. So that's always going to be our prioritization on the asset side of the ledger, on the left-hand side the balance sheet.

I wouldn't be surprised to see a little bit of a spread give back, because you had spreads dropping as LIBOR was increasing. So a little bit of the opposite dynamic occurring in the inverse, I think it's reasonable to assume to offset.

And we do have LIBOR floors in number of our deals, where we act as agent. We've attempted to set LIBOR at close to prevailing rate, so new originations on an agented basis in the last year. So we're in the 200 plus LIBOR category.

Also in our controlled investments we're somewhat insulated from that because we've got the ability to sustain yield. On the right-hand side of our balance sheet, as John mentioned in our opening remarks, we have been trimming our cost of capital. And while respecting and maintaining diversity of access in multiple debt capital markets, we have been prioritizing those that we deem to be more efficient and appropriate from a risk management standpoint. So that means our programmatic issuance has been prioritized and we've trimmed the cost of that capital by at least 150 basis points in the last six weeks alone.

We also expect to be prioritizing and already are, usage of our revolver, which we just extended and amended in the past year, which gives us longevity from a maturity standpoint, that's obviously floating rates that will benefit by increasing usage.

And we've been retiring debt in our near-term maturities, especially more expensive cost of capital. The convert market is a good example of that, which is just a flat out more expensive place to issue, just even if you assume it's close to pretty much a debt instrument with significant amount of the money equity option embedded. Just the coupon demanded by a finite set of investors is much higher than in other markets. That's also true of the more wire house-centric baby bond market, which you've seen us de-prioritize. So just institutional paper in general.

So we have been aggressively calling our program notes that mature over the next two years, see us extending that. And that’s a significant benefit. We don't like getting stuck with non-call life or significant [indiscernible] call it paper in institutional market. So it's both more expensive and inflexible as folks that they're getting paid above the market rates without much we can do about it. As we rotate more of the book to programmatic notes issuance, we've actually migrated that issuance from being able to call it only twice a year in specific dates to, in the not too distant future, the ability to call in pretty much a continuous fashion. So, significant flexibility from that standpoint as well. So we're constantly shaping the right hand side of the balance sheet, while still respecting counterparty diversity as well as type of issuance diversity.

So -- and the other point I want to make about LIBOR, our real estate business is a significant beneficiary of a reduction in treasuries, medium to longer term treasuries is a lot of pegged off of the 10 year treasuries for GSE spreads and buyer expectations, et cetera. So it's not just about shorter term LIBOR as you referenced, but also the rest of the curve. And that shows up both as a seller as well as a buyer. We talked about modernizations we've had to-date. We've got others pending, including ones under contract. And buyers of those assets who layer on new financing get the benefit and can pay up in essence for our assets. And we've generated in north of 25% IRRs off of those deals.

And then on the new deployment front, we get attractive financing terms as well and of course try to purchase outside of the mainstream and smaller deals in Tier 2, Tier 3, Tier 4 markets that are less picked over ideally in an off-market fashion. So, interest rates cut their way in different parts of the curve across our whole business and we try to make intelligent optimization decisions at all points along the way.

Anything John you would add to that answer?

[John Barry, Chairman and CEO]

Okay. Is that helpful, Robert?

[Robert Dodd, Raymond James]

Yes, that's helpful. If I can two quick follow-ups to that. To your point, Grier, we can see spreads give back and they do tend to widen when rates come down. The ability to kind of capture that depends on how fast a portfolio turns over for the most part, right? And so, over the last year, we've seen relatively lower turnover in your portfolio, I mean about $600 million in repayments, about 10% of the portfolio '19 versus much higher than in '18 and '17. So, that turnover has slowed down asset life [indiscernible], that reduces potentially the ability to capture that spread widening. So, should we expect that your turnover within the portfolio should be accelerating, or -- and/or kind of the asset life shrinking to take advantage of those widening spreads?

[Grier Eliasek, President and Chief Operating Officer]

Yes. Portfolio turnover is a little bit tricky measure, I think the way you're describing it, Robert, because there are two important pieces to that. One is NPRC as a controlled investment, looks like it never turns over. But in reality on an underlying individual asset basis, we are exiting up to seven assets per annum. That's the tax REIT maximum that's allowed as per the rules, we've been coming close to that. So we actually have been turning over that particular book. Also, in our structured credit business, when we do an extension we actually maintain the same two-step. And so it looks like it's not turning over and it isn't. But the asset is actually changing in a positive way by extending tenor of the deal, which allows us to do one of and ideally two things simultaneously. One, by extending the deal, purchase a wider spread, longer dated assets as per individual indenture weighted average life test. And number two, reduce our cost of liability financing. So -- and there's turnover that happens also in the individual deals where you're seeing spread widening finally on the asset front. I mean 2018 was the year of asset compression and now we've had three straight quarters of asset spread widening that benefits us and of course both liabilities and assets are floating rate. So you only have kind of a stub floating rate exposure for the sort of unhedged portion, which is your investment amount essentially. So we're getting some capture back there.

In terms of middle market book and that turnover, we are getting repayments occurring to start increase a little bit. It's been a very tricky market, because every time there's a significant bout of volatility, if you like it, it impacts your M&A that's such a big driver of origination activity of course in our business and you saw things slow down dramatically at the end of last year, then start to pick up again this spring. Then it slowed again with the part seasonality in the summer and then another bout of volatility.

So -- and part of it has also been our proactive turnover, because we're doing a lot that we talked about to manage risk and to prepare for the downturn that -- while some people have been predicting it for five years, I guess if you predicted five years ahead of time, you're right eventually. But eventually the cycle turns and we want to have the strongest fortress to handle that and be a net beneficiary of that situation in terms of buying other platforms, buying assets, et cetera. We've benefited significantly from that risk management in the last downturn.

It's like we have made our business even better especially with counterparty risk reduction. But we're also trimming our excess concentration exposures we see. You haven't seen us on the new origination front add, kind of multi-hundred-million-dollar exposures. We've been clubbing more. We've been selling down more. We're very reluctant to take on that risk. So there's an element of turnover happening there as well.

And traditionally, the kind of more agented middle market business was the more attractive place. We've seen a migration of covenant wide that book. You've seen some unwieldy and not pretty smart capital structures, because that's really where the influx of capital has occurred. It's in the middle markets, not as much in the syndicate market, like you've seen a net withdrawal of capital, because so much was pegged to interest rate expectation.

So just a long way of saying, we're saying now a lot more often, to middle market deals that are smaller credits that need to have lower leverage structures and lower adjustments allowed et cetera. And there's a lot of capital that’s been raised, it has to go somewhere. So there's a lot of things that go into the portfolio turnover equation, Robert.

[Robert Dodd, Raymond James]

Got it. I appreciate it. One quick -- maybe quick…

[John Barry, Chairman and CEO]

Hey, Robert. It's John. I think you got the gist of it, which is that, there is more than one natural hedge in our business, right? We are funding ourselves to PCF, which is our -- I guess, our incremental swing factor funding source, that's floating rate. So as LIBOR declines that source of funding goes down. Our company -- our portfolio companies are funding themselves primarily with LIBOR based paper. So lowering interest rates is intended to make their life easier and does, all things being equal.

So just to mention, just those two items are examples of the natural hedge in our business. It is true, I think, that we would prefer much more inflation and much greater spreads. But I think that would erode the real returns to our shareholders. So as far as our shareholders are concerned, measuring real returns, I believe that they are net winners as interest rates decline.

[Robert Dodd, Raymond James]

Yes, I appreciate that John. Just one more I got on the REIT. In the past you told us something like the dividends from the REIT correlate with exits because it creates a taxable event, et cetera, et cetera. And in your commentary Grier, John, you said that you've got a number -- you've done a number of exits and got a number that are coming soon. So would it be fair to say that there should be more dividend income from the REIT or is that any gains within that more likely to be reinvested?

[Grier Eliasek, President and Chief Operating Officer]

So I would describe our outlook for NPRC as a reasonably stable within a band income distribution expectation. And based on assets that we have already exited, as well as ones that are under contract, as well as ones we expect to be under contract soon, we think we have over two years of kind of rough run rate income distributions in effect banked probably more like 2.5 years. And then we would be looking to add to that by exiting other assets as we identify them. And essentially what we do is every quarter reupdate our cash flows and run NPV analysis of the individual assets. Should we exit? Should we refinance? How should we refinance and what tenor and structure should we do a dividend recap, a so-called supplemental financing? Should we stick with the GSE, Fannie and Freddie? The CMBS bid has actually become more competitive off late, in part because the GSEs are reaching some of their regulatory maximums for multi-family. So it's nice to see the private bid come in more strongly.

So we do all these things and when that spits out of the analysis to exit, we do so with an optimal fashion. So we feel very good about the sustained cash flow income generation power of that business to get multiple years in effect banked. And we're looking to add to and extend that tenor.

[Operator]

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

[John Barry, Chairman and CEO]

Yes, so I think we're all set. Thanks everyone. Bye now.

[Grier Eliasek, President and Chief Operating Officer]

Thank you.

[Operator]

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