Prospect Capital Corp (PSEC) 2015 Q1 法說會逐字稿

Good morning. Welcome to the Prospect Capital Corporation first fiscal quarter earnings release conference call.

(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, Dan. Joining me on the call today once again are Grier Eliasek, our President and Chief Operating Officer, and Brian, 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 forecasted 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'll turn the call back over to John.

Thank you, Brian. We're excited this morning to announce a strategy that we have been working on for many months to pursue spinoffs of certain businesses in our portfolio, including our CLO structured credit business, online lending business, and real estate business. We believe spinoffs have significant potential to unlock shareholder value through pure play, earnings, multiple expansion, moving strategies into faster growing non-BDC formats with reduced basket and leverage constraints, and freeing up 30% basket and leverage capacity for new originations at Prospect.

These strategies have grown rapidly for us in recent years, and we believe spinoffs will provide the expanded capacity to continue that growth. We anticipate these non-BDC spinoffs will have tax-efficient structures.

We would likely seek to spin off these businesses in conjunction with capital raises for each such business, with a goal of leverage and earnings neutrality for Prospect. The size and likelihood of these spinoffs, which may be partial rather than complete spinoffs, remain to be determined.

Our target timing for completion would be in early 2015. Prospect Capital will continue as the only multi-line BDC in the marketplace with a continued diversified focus on originations that includes its strategies being spun out.

Now, on to our financial results for the quarter. Our net investment income or NII, in the September quarter, was $94.5 million or $0.28 per weighted average share. Our net income was $84.1 million or $0.24 per weighted average share.

As a tax-efficient regulated investment company, our shareholder dividend payout requirement is based on taxable income rather than GAAP net investment income. Taxable income can decouple meaningfully from such net investment income.

In the September quarter, we generated taxable income of $151.3 million or $0.44 per weighted average share. That is $0.11 per share more than our dividends last quarter. This is the first time we have reported our taxable income in our earnings release, and we think it is helpful disclosure to show that we've been covering our dividends out of taxable income.

In our earnings release we have a detailed reconciliation of net investment income to taxable income for the September quarter. That table shows $0.11 of the $0.16 difference related to a significant dividend related to Echelon Aviation, our aircraft leasing business. Excluding this Echelon impact, our taxable income in the September quarter was $0.33 per share, approximately the same as the dividends per share Prospect paid to shareholders during that period.

As described in more detail in our release, the other $0.05 relates to our CLO business, generating higher taxable income which roughly tracks cash income, then GAAP income on a recurring basis throughout the life of each CLO. Our CLO business performance has significantly exceeded our expectations, demonstrating the benefits of our strategy of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance, and focusing on the most attractive risk-adjusted opportunities.

As of September 30, we held $1.16 billion across our fleet of 36 non-recourse CLO investments. Our underlying CLO portfolio consisted of over 3,100 loans and a total asset base of over $16.2 billion. As of September 30, our CLO portfolio experienced a trailing 12-month default rate of 0.16%, significantly less than the broadly syndicated market default rate of 3.34%. In the same quarter, this portfolio generated an annualized cash yield of 20.7% and a GAAP yield of 14.9%.

We had previously announced our shareholder distributions through January 2015. The January 2015 dividend will be our 78th shareholder distribution and the 55th consecutive per share monthly increase. Because we have already announced several upcoming months of dividend distributions, we plan on announcing our next series of dividend distributions in February.

We've generated cumulative taxable income in excess of cumulative dividends to shareholders since Prospect's IPO over 10 years ago. From the IPO through September 30, 2014, our taxable income is $70.5 million in excess of dividends to shareholders, which represents $0.20 per share.

Since our IPO 10 years ago through January 2015 distribution at the current share count, we will have paid out $13.37 per share to initial continuing shareholders, and $1.4 billion in cumulative distributions to all shareholders. Our NAV stood at $10.47 on September 30, down $0.09 from the prior quarter.

We've delivered solid returns while keeping leverage prudent. Net of cash and equivalents, our debt to equity ratio, was 71.3% in September, down from 72.9% in March.

We have substantial liquidity to drive future earnings through prudent levels of matchbook funding. We are currently pursuing initiatives to lower our funding costs, including refinancing of existing liabilities at lower rates, opportunistically harvest certain controlled investments, optimize our origination strategy mix, and rotate our portfolio out of lower-yielding assets into higher-yielding assets, while maintaining a significant focus on first lien senior secured lending. Our Company has locked in a ladder of fixed rate liabilities extending 30 years into the future, while most of our loans float with LIBOR, providing potential upside to shareholders should interest rates rise.

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

Thanks, John. Our business continues to grow at a solid and prudent pace. Prospect is now scaled to over $7 billion of assets and undrawn credit. Our team has reached approximately 100 professionals, which represents one of the largest dedicated 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 lending, direct non-sponsor lending, Prospect-sponsored operating buyouts, Prospect-sponsored financial buyouts, CLO-structured credit, real estate yield investing, online lending, aircraft leasing and syndicated lending. At September 30, our controlled investments at fair value stood at 26.6% of our portfolio.

This diversity allows us to source a broad range and a 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.

Prospect's originations, in recent months, have been well diversified across our nine origination strategies. Prospect has originated nearly $3 billion of closed investments so far during the 2014 calendar year.

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. At September 30, our portfolio's fair value consisted of 54.7% first lien, 20.1% second lien, 18.5% CLO structured credit with underlying first lien assets, 0.2% small business whole loan, 1.5% unsecured debt, and 5% equity investments resulting in 93.3% 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, and our debt investments were generating an annualized yield of 11.9% as of September 30. We also hold equity positions and many transactions that can act as yield enhancers or capital gains contributors as such positions generate distribution.

While the market has experienced some yield compression in the past year, 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. Originations in the September quarter were $887 million across 11 investments. We also experienced $863 million of repayments from five investments as a validation of our capital preservation objective.

During the September quarter, our originations consisted of 76% third-party sponsor deals, 7% real estate, 6% online lending, 5% CLO structured credit and 4% operating buyouts. As of September 30, we held 140 portfolio companies with a fair value of $6.254 billion, demonstrating both a long-term increase in diversity as well as a migration toward larger positions and larger portfolio companies. Our number of companies is up 9% and portfolio size is up 37% year over year.

We also continue to invest, in a diversified fashion, across many different portfolio company industries, with no significant industry concentration. The largest is about 10%. Our financial services-controlled investments and CLO-structured credit investments are performing well, with typical annualized cash yields ranging from 15% to 30%.

To date we've made multiple investments in the real estate arena with our private REITs, largely focused on multi-family stabilized yield acquisitions with attractive 10-year financing. We hope to increase that activity with more transactions in the months to come.

We closed our platform acquisition of CP Energy in the September 2013 quarter, and closed multiple follow-on acquisitions in the December 2013 quarter. In the March 2014 quarter we closed the Harbortouch acquisition, with the simultaneous financing of an add-on acquisition, with other add-on acquisitions being completed thereafter including, in the September quarter.

In the June 2014 quarter we closed the Arctic Energy acquisition. In the September 2014 quarter we exited AirMall at a 17% IRR and 1.6 times cash and cash return. And we recently exited the Ajax investment.

We currently have other one-stop acquisitions under LOI or near LOI at attractive multiples of cash flow, with both double-digit yield generation and upside expectations. In the June 2014 fiscal year, we made three investments in non-controlled third-party sponsor-backed companies that brought our total investment in each such company to more than $100 million. And in the September quarter, we made another two such investments, demonstrating the competitive differentiation of our scaled balance sheet to close one-stop financing opportunities. We have also made multiple control investments that each individually aggregates more than $100 million in size.

Over the past year, we have also entered the online lending industry with a focus on prime, near prime, and subprime consumer and small business borrowers. We intend on growing this investment strategy which stands at just under $100 million today, across multiple third-party and captive origination in underwriting platforms. Our online business, which includes attractive advance-rate financing for certain assets, is currently generating a yield in excess of 15%.

The majority of our portfolio consists of agented and self-originated middle-market loans. In general, we foresee the risk-adjusted rewards in the current environment to be superior for agented and self-originated opportunities compared to the syndicated market, causing us to prioritize our proactive sourcing efforts.

Our differentiated call center initiative continues to drive proprietary deal flow for our business. As a yield enhancement for our business, earlier this year we launched a senior loan initiative in which we expect to collaborate with third-party investor capital that would acquire lower-yielding loans from our balance sheet, thereby allowing us to rotate into higher-yielding assets and to expand our ability to close scale, one-stop investment opportunities with efficient pricing. We hope, but cannot guarantee, to close this initiative during the next few months.

Our credit quality continues to be strong. Non-accruals as a percentage of total assets stood at less than 0.1% at September 30. We have booked $277.4 million of originations so far in the current December quarter.

Net of $103.7 million of repayments we've delivered $173.7 million of net originations so far this quarter. Our advanced investment pipeline aggregates more than $200 million in potential opportunities, with significant near-term additions expected, boding well for the coming months.

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

Thanks, Grier. As John discussed we've grown our business with prudent leverage, including in the June quarter through two scale, unsecured term debt offerings to help drive our earnings. Net of cash and equivalents, our debt to equity ratio, stood at 71.3% in September, down from 72.9% in June.

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 fixed-rate liabilities extending 30 years into the future, while most of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise.

We're a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, conduct an ATM program, develop a [notes] program, issue an institutional bond and acquire a competitor, as we did with Patriot Capital. Shareholders and unsecured creditors [alike] should appreciate the thoughtful approach, differentiated in our, industry which we have taken toward construction of the right hand of our balance sheet.

As of September 2014 we held more than $4.9 billion of our assets as unencumbered assets, representing approximately 78% of the portfolio. The remaining assets are pledged to Prospect Capital Funding LLC which has a AA-rated $810 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, a 50 basis point reduction from the previous rate, and revolves for 4.5 years followed by a one-year amortization, with interest distributions continuing to be allowed during the amortization period. We informed shareholders and analysts during our last earnings release that we wouldn't reduce our cost of capital and extend our revolver, and we did so promptly during the month of August.

Outside of our revolver and benefiting from our unencumbered assets, we've issued at Prospect Capital Corporation multiple types of investment grade unsecured debt, including convertible bonds, a baby bond, institutional bonds and program notes. All these types of unsecured debt have no financial covenants, no asset restrictions and no cross defaults with our revolver.

We enjoy a BBB rating from S&P and a BBB-plus rating from Kroll. We've now tapped the unsecured term debt market to extend our liability duration up to 30 years. We have no debt maturities until December 2015, with debt maturities extending through 2043. With so many banks and debt investors across so many debt tranches, we've substantially reduced our counterparty risk over the years

As of today, we have issued six tranches of convertible bonds, with staggered maturities that aggregate approximately $1.25 billion, have interest rates ranging from 4.75% to 6.25%, and have conversion prices ranging from $11.23 to $12.61 per share. In the past, we have repurchased such bonds when we deemed such purchase to be attractive to us.

We have issued a $100 million 6.95% baby bond due in 2022 and traded on the New York Stock Exchange under the ticker PRY. On March 15, 2013 we issued $250 million of 5 7/8% senior secured notes due in March 2023. This was the first institutional bond issued in our sector in the last seven years. On April 7, 2014, we issued $300 million of 5% unsecured notes due July 2019.

We currently have $784 million of program notes outstanding, with staggered maturities between 2016 and 2014, and a weighted average interest rate of 5.38%. With the closing of the facility, one condition precedent to our borrowing required an increased level of equities for us to fully utilize the $810 million of commitment. Our Board believed it was in the best interest of shareholders to raise a modest amount of additional equity at a discount to NAV to enhance liquidity and maximize access to low-cost facility financing. We have raised approximately $95 million of equity capital from September 11 through November 3 at an average price of $10.03 per share.

We currently have drawn $20 million under our revolver. Assuming sufficient assets are pledged to the revolver, and that we are in compliance with all revolver terms, and taking into account our cash balances on hand, we now have over $660 million of new facility-based investment capacity.

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

Thank you, Brian. We can now answer any questions, if anyone has any.

(Operator Instructions)

Our first question comes from Terry Ma of Barclays.

Hi, guys. Can you maybe just give us a little more color on the process for the spinoffs and what type of approvals you need? And also how you're thinking about the 30% bucket after you spin the CLOs off?

Each of the three strategies would be, at this point, a separate registration statement that we would file. We would likely not file publicly the registration statements that are non-reg formats and avail ourselves of the Jobs Act benefits, being able to get the regulatory process done confidentially, and then have that information go out when you're closer to the point of these spinoffs.

So, the main approval would be a regulatory one but we have spent a good part of the last two years -- this is something we've been working on for a long time, which characterizes a lot of the projects. We don't always talk too much about them but we have a lot of interesting ideas going on at all times. And this is one we have been working on with the regulator to devise a program that we think will be successful. We're not going to go into the specific mechanics on this call, and probably because we don't necessarily want to give a road map for others, and think this is a distinctly Prospect advantage to be putting that out there.

In terms of the 30% basket with the CLO structured credit investment, our goal is for this to be leverage and earnings neutral, meaning we do the spinoff and we have the ability to replenish similar assets back at Prospect. The vehicle that we would spin the CLOs off into -- and we'll have the specifics on that structural piece later -- again we don't want to give others a road map for our proprietary ideas -- would be a non-30% basket type of structure. That would allow those business -- that business, in particular, which is constrained with our balance sheet today, A, because of the 30% basket; B, because of the leverage and adjusted leverage ratios that we need to operate under appropriately to sustain our longstanding investment grade rating, which we enjoy and want to continue.

So, to spin off into a non-rated entity without a 30% basket is valuable. And we think, really, the biggest, biggest piece here, from a shareholder perspective, is the potential multiple expansion from allowing these investments to stand on their own two feet in a pure play construct. If you look at comps, for example, on the CLO side, they've tended to trade at a premium to book value when just about the entire BDC industry right now is trading at a discount to book value. So, that's something we like to avail ourselves of if we can.

And this is true far beyond the CLO structured credit business. You look at the real estate industry and REITs have long traded at higher multiples, lower cap rates and lower dividend yields than their BDC brethren. So, we think we could potentially unlock value there, as well.

And perhaps the biggest hoped for -- not guaranteed but hoped for and anticipated -- unlock is our burgeoning online lending business. As many folks on this phone call are probably aware, there are multiple IPOs being planned of some significant size, originators and the online lending business, who have done private rounds at more tech-like multiples than finance co multiples. And if we get any even a small portion benefit from that type of a multiple in spinning off our online lending business, then that could be a very, very attractive proposition for shareholders.

There's so much growth embedded in that marketplace right now because of technology, because of ease of access for customers, whether they are consumers or small businesses, wanting to obtain term financing in a straightforward way from a non-bank lender community, that there's significant growth going on. In our portfolio right now, on a Prospect investment basis, it's just under $100 million, that's our investment. There's ready made financing for that industry, as well.

We have warehouse lines with multiple banks that we continue to expand. We're looking at implanting securitizations in that marketplace where ones have already occurred over the last year.

So, these are readily financeable assets because of the granularity, as well as the performance of these cash flowing loans over the course of the last cycle and the last recession. So, we think in its own pure play vehicle we can unlock a lot of value, in particular, with that one.

Great. Just switching gears, can you maybe give us some more clarity on the Echelon repayment? Because the $38 million looked like a repayment in principal. So can you maybe just walk us through how that can be recognized as taxable income?

Sure. The actual event happened at a company that we've invested in called Air Lift. Air Lift received some insurance proceeds from a plane. It gets a little complicated because a lot of tax depreciation and stuff comes into play, but the answer is that at Air Lift it actually generated a gain because it had been depreciated significantly from the original purchase price of the plane.

When it generated that gain and Air Lift made a distribution to Echelon, that distribution was, for tax purposes, a dividend distribution. When Echelon received the dividend distribution, it utilized the cash to repay its loan to Prospect rather than declaring a dividend to Prospect. So the money that came to Prospect from a GAAP standpoint was a pay down on its loan.

From a tax perspective, Echelon itself is a LLC that's taxed as a partnership. The partnership then, anything that comes to Echelon -- which, if you remember the Air Lift money came to Echelon as a dividend -- Echelon would record it as dividend income, and therefore, because it's taxed as a partnership, its brought over to the Prospect tax return as a dividend rather than as a debt repayment.

Okay, maybe I'll just follow-up offline in a little more detail.

Maybe I can try. We consolidate the Echelon entity for tax but not GAAP. As we do for any LLCs.

When a RIC owns an LLC that's taxed to the partnership it consolidates that LLC on its tax return. So, hopefully that is a short answer that's helpful.

So, why was the decision made to dividend the proceeds up instead of reinvest it into the business? Because it looks like you guys also marked down the equity position in Echelon by $9 million this quarter?

When the cash comes to you, it's deemed to be a distribution from a subsidiary of Echelon. So, it's coming to us as a distribution.

We can put capital back into Echelon at any time to fund new investments that we deem appropriate. And at any given point in time we're looking at various other aircraft transactions.

But we're generally not a huge fan of leaving significant amounts of cash just laying around at controlled portfolio companies. We like for cash to be in use and productive for us at all times.

Okay, great. That's it for me, thanks.

The next question comes from John Bach, Wells Fargo Securities.

Good afternoon and thank you for taking my questions. And very interesting proposals put forth.

Perhaps if we start to talk a bit about liquidity at the moment. Grier, at 0.72, 0.71 debt to equity, how much do you believe you have available to grow the balance sheet today and still remain within your target or comfortable leverage range?

Sure. I think there's a couple ways of looking at it. One is risk management comfort and the second is a somewhat rating agency-driven view of leverage.

On the former, we have a 93% secured debt portfolio and a majority first lien portfolio that's performing very strongly. We view these as highly leveragable assets.

From a rating agency perspective 0.85 tends to be the typical investment grade cutoff of debt to equity. That doesn't mean if you go over for one nano second it's a problem, but just on a long-term basis as a maximum place to run.

That gives us a decent amount of liquidity today because we're running more in the low 70%s currently on a debt to equity ratio basis. So, we do have available capital, even if you didn't have a single repayment or single asset sale.

But then you have repayments, of course, that occur. We had over $800 million in the last quarter, and so far in this quarter we've had $104 million approximately of repayment.

When you get to the size book that we have, and a mature and seasoned book, you're going to have a fair amount of repayments. They will be lumpy, just like originations, but we'll have them.

There's a couple other additional storehouses of liquidity for us. One is the senior loan initiative, which is an important one, where we spent a ton of time on over the last few months, which is a portfolio rotation strategy to sell off our lower-yielding assets.

We've got -- what would you say, Brian? -- $600 million, $700 million of assets in the 6% to 7% yielding range. And if we can sell those in a thoughtful manner, one in which we retain ball control over the credit, which is very important to us, and rotate into higher-yielding assets, that will be significantly accretive for our business and for shareholders.

Got it. Then, Grier, the question is -- and I'm sure investors have the same thing -- if you have all these available buckets of liquidity why did you raise $100 million of equity capital below book value?

As we disclosed in our release, we have an additional condition precedent pertain to allowable advances on our credit facility. Which basically you can think of it as an equity raise requirement in order to fully draw on the facility in financing.

We were quite pleased, John, last quarter, within a week of telling folks we were going to go reduce our cost of funding, we delivered and did just that, and reduced our spread by 50 basis points. And that's financing that we like to have the ability to utilize.

On the equity issuance front, we have, for two years and growing now, declined to focus on discrete -- we call them GAAP down -- equity offerings as part of our strategy, unlike other peers. And have chosen to access from time to time at the market equity. We like it because it's efficient funding, it's low cost on a underwriter spread basis, and it's just-in-time capital to assist with us.

Our desire is to minimize that as much as possible, particularly in a below book environment where we find ourselves, along with probably 90% of the BDC community at the present time. But that was the logic and rationale and justification for doing so, John.

I appreciate the explanation. You obviously, it's no secret that when we look at capital raises at high yields, which effectively translate into high required asset yields that you need to put on the book to make that equity issuance accretive, obviously we have questions -- and still do but appreciate your answer. The question as it relates to the spinoff, what we find it interesting, at the end of the day investors are going to end up owning, whether it's on your balance sheet or in the public liquid form, the portfolio that's generating net earnings and dividends.

So let's look at it holistically for a moment rather than some of the parts split up here at the moment. Maybe this question is, do you believe that the earnings power of the entirety of this business can cover your $0.33 dividend?

I'm not sure. I'm trying to understand your question. When we spin the business we're looking to grow the business and grow the distributions of the spun companies, and we're looking at it first and foremost -- well, let me back up and say this. We have covered, and more than covered, our dividends out of taxable earnings over the life of our company, and significantly in the past quarter.

We have under-distributed to the tune of over $70 million that we have built back in a spill back fashion. So we are currently not only covering but over covering.

The question is, then why haven't you declared the dividends in the future, as you normally have at the same consistent if not growing level?

We have concluded that setting forward your dividend many months in the future -- and we've done that in the past -- we're not sure that we've captured, quote/unquote, credit for doing so. And we noticed that the vast bulk of the industry declares a dividend on or about the time that they are announcing earnings for the subsequent months. And, so, we as a Board have decided to do that and have maximum information at that time.

At the same time, we spend a lot of time pulling together the data and making sure we put out there significant disclosure this quarter related to taxable earnings. We think that's very important disclosure. We think it shows where we are.

And we think, the bottom line is, the taxable earnings distributions are required distributions. So, we're making required distributions to our shareholders.

Great point, and I understand it. When you think about taxable income, we understand the $0.11 that came off of Echelon, but it's the $17.5 million of taxable income coming off your CLO book, roughly $0.05 a share, which I believe, John, if we took that out, as you said, that $0.33 was covered if you remove the Echelon, but it would also fall below the dividend if you included the taxable income from CLOs as, we'll call it, less stable. I'm curious as to how you believe that is recurring in the future. Can you explain how those CLO cash distributions are in fact recurring at that same level, given that you mentioned that they were recurring in nature in the press release?

John, it's Brian. They are recurring. The answer is that since these CLOs are still in their reinvestment stage, the balances aren't going down. That's the only time that the amount that the excess would be decreasing. So, they continue to generate cash distributions in excess of what we're recognizing as GAAP earnings.

What happens if they go into the reinvestment period, Brian?

When they go into the reinvestment period we actually have the right -- because all of these we hold a majority interest in -- we have the right to actually call them at that point. So, we can control when the call happens on these. We have optimized when that time is -- it's generally 9 to 12 months after the end of the reinvestment period -- to maximize our GAAP returns and our cash returns.

So, what you're saying is when you've called a CLO, you're going to be effectively able to earn the same cash-on-cash returns that you're earning today in, effectively, perpetuity?

At that point we would replace the CLO as a new CLO and that would start the whole process over.

It's just a question to get at and to help us. I think the cash-on-cash returns you're booking are significant -- no? And the question is, if there will be an environment where the cash-on-cash returns and the CLOs will no longer be what they're at today, whether it's credit losses, whether it's increasing interest rates, et cetera. So I'm just trying to understand how this number is recurring.

I think there's a lot of misconception that comes to CLOs, and this is a great question to get at that. CLOs, when you focus on primary issuance, are really arbitrage vehicles. And you can make money buying primary issuance CLOs, particularly when you're in the majority and you build the deal around you, and you get the best economics in the picture, whether you're in a low spread environment, a high spread environment, a low interest rate environment, a high interest rate environment, a low credit loss environment, a high credit loss environment, a recession, or a bull market, because the moment you're pricing the deal you're looking at the assets and you're looking at the liabilities, and you're capturing the positive spread between the two and they both move.

So, if you have a lower-spread environment going with assets, then you're going to make sure the model works such that you're getting very attractive AAA spreads and other liability pricing. If you're not getting those attractive spreads, you don't price the deal, and we take our cash and invest in something else in our business that's attractive. Maybe it's the online lending business, maybe it's an attractive buyout like the Harbortouch deal we did, whatever. We have full optionality of what we want to do.

But these businesses have generated strong returns in every vintage going back over the last 15 years. It's not an asset class where you've got three good years and two terrible years and three good years. That's not what the data shows at all when it comes to CLOs.

At the same time, as with any of our investments, we're not attached to something saying we're going to invest, take the call from a CLO and invest it in a new CLO on a no-matter-what basis. We're going to study that very carefully against a very wide and disciplined investment purview and decide where we want to put that capital. We're not long and strong just doing that, or any of our other strategies.

Appreciate that, and definitely appreciate the view. The question is, it's not necessarily about return because CLO returns are made up of NAV and NIM. You've got the potential for NAV expansion or the potential for distribution.

And if we are operating at BDC, distributions are what matters, right? And so, I guess, Grier, what you're saying is the distribution levels that come off these CLOs will be fairly static in any environment. Is that how I interpret what you're saying?

No, I'm not saying they are going to be static in any environment. But what I'm saying is -- there's a couple things. One is, I was responding to your question about when a deal rolls off what does life look like when you're trying to invest into a new deal?

The second question you're just getting at there is, what is the resilience of these vehicles to withstand credit losses? And there's a significant resilience because you don't have financial covenants in a CLO, in a securitization structure, you would have with, say, bank financing or any other type of leverage. Securitization debt is arguably the best type of debt you can have because it's matchbook funding.

These are self-healing vehicles where even if you trip it over a collateralization test it just goes to purchase new assets. Our volatility is also your friend running a CLO. The more volatility you have in loan prices, it means your fleet of deals can go and buy assets at a discount to par, return par, and then all of that accrues to your benefit.

[Apatos] -- CBC Apatos 8 is a great example, which is a deal we called a year ago and captured north of 32% IRR. When we printed that deal a couple years prior, it was, I think, during one of the European mini flash crashes. Spreads had widened.

The liability costs were actually much higher than they are today. But the yard worked very well. And because we were able to buy assets at a steep discount, the deal benefited substantially from a pull to par strategy of those loans in trading back to par.

With a CLO, there's really two primary risks to keep in mind. One is loss risk and one is reinvestment risk.

On the loss risk front, we protect against that risk by, number one, doing primary issuance where we underwrite the collateral in conjunction with our management team. Number two, we're in the majority seat so we can throw our weight around for the deal and what collateral shows up there.

Number three, we work with only the best management teams who have the best track records on the reinvest to protect against a lawsuit. Number four, we insist upon only printing deals with a very strong [modeled arm] with a high ability to withstand losses.

We've modeled, out with our deals, that the default rate could jump to as high as 8% to10% per annum, and run at those high unprecedented levels every single year for the life of the deal and we still wouldn't lose money. That's what I call a resilient structure.

The second risk is reinvestment risk, where times get too good and spreads diminish as loans repay and prepay. And we manage that risk by being in a majority seat and we can call the deal whenever spreads start to diminish and your spread should decline.

You do not get that right if you are just a [bid] player in the deal if you only owned 10%, 20%, 30%. You only have that right sitting in the majority seat, which has been our disciplined, distinct strategy for many years now that's worked out quite well.

Appreciate it, Grier. And, guys, honest questions, honest answers. Thank you so much.

Our next question comes from Robert Dodd of Raymond James.

Hi guys. Obviously still focusing on the spinoff such that the topic of the day. First on the online lending strategy, you say you've got $100 million currently. Where is it?

Because I've gone to the schedule of investments and I don't see it standing out anyway. You've got $12 million in whole loans, which I know what those are, but where is the other $88 million?

It's a great question. We hold our small business loans directly on Prospect's balance sheet. And that includes our on-deck loans, that includes the portfolio we purchased from direct capital that was sold to CIT and another part of the business, and we bought this part of the business. That was in early July.

We've got very exciting initiatives in place to grow our small business strategy. It's a good 70% basket asset and very attractive returns, especially if you can strike advantageous yields with lower origination promotes.

So, we've been out there and there's a number of companies looking to grow in that space. So, stay tuned for more. We're hoping as we end this year and get into 2015 to see stepped up growth in the small business lending portfolio.

The other assets sit within National, which is one of our portfolio companies, which is actually structured as a REIT and is run by a management team with a background in online lending and other types of specialty finance businesses. And that's where our existing warehouse bank financing resides for that consumer business.

So, our consumer business is within National, Robert. And we have multiple banks now in one warehouse line. We're looking at adding a second warehouse line with similar banks and hopefully new ones, as well. We're working on a securitization right now.

And the model returns -- it depends on whether you're talking about super prime, prime, near prime or subprime -- we really have almost no subprime, it's all really in the first three categories right now. We model out returns in a consumer book on a warehouse basis in the 15% to 20% return range, which is a yield, as well. And then when you securitize those assets we can drive that well into the 20% if you're talking about an unrated securitization.

We're also looking at potential rated securitizations which would go even higher than that. So, these are highly financeable assets.

Just to be clear, though, is there an origination platform within your REIT? Or is this basically just a wholesale buying business?

It's a little bit of a hybrid, Robert, in the sense that, with the larger originators who are more established, we're one of a small number of institutions typically that's doing significant buying. We've been an early player in the marketplace. And we define the precise parameters for what we want. So, call it a hybrid there.

For some of the more nascent originators -- and, as you can imagine, this is a high-growth market where you have a lot of capital being raised for originators to go after this market opportunity, which is a distinct and compelling value proposition for consumers and for small businesses -- and we're striking advantageous deals with those players. And we've also looked at our own origination platform formation which has its own pluses and minus.

We'll likely have a multiple-pronged approach that includes many of those. We like to have diversified access to originations, much like we do at Prospect itself, and wanting to be able to stimulate our own deals, as well as look to intermediary sources of flow. Right now we have several platforms that are sources of flow and we expect for that number to only increase in the future.

Robert, John. I'm glad you asked about our own origination because I'm counting you as agreeing with me that's a very important priority for us. We have been very busy setting up our underwriting criteria, developing relationships, sourcing, selecting, negotiating the loans the loans that existing platforms bring to us. So that's taken a good amount of our time.

In parallel, we have looked at getting our own origination platform up and running. I would like to see that happen. And I'm glad to hear you're wondering about it too because that gives me some more wind in my sails on that project.

On bridging or spanning the gap between -- well, not gap -- the connection in terms of returns to shareholders, if, via the REIT, et cetera, you're generating north of 20% returns, and potential to expand that further with securitizations, why, frankly, both with all these spins for the CLO and everything else? Just sell the CLOs to the mark-to- book, take the gains, redeploy that capital into the online lending business that generates higher cash returns than the CLO business does, and the cash and GAAP returns are comparable, and that level yield analysis versus cash flow analysis.

It would seem to me that shareholders would be better off if you just, frankly, dumped the CLO business for a gain and invest it at higher returns in this new initiative. Why go to the extra complication?

And we're looking at optimization decisions like that all the time. We sold a couple of CLOs in the current quarter. I think the bottom line for us is earnings multiple expansion.

When you look at our business -- which we feel has performed strongly for a decade plus, been resilient across recession, a buyer of other businesses, has a diversified platform with low losses -- we look at our forward earnings multiple at a significant discount to the peer group. And we say -- hmm, one reason for that may be our business -- while we view it as a sign of strength to be diversified, to be able to be disciplined and say -- I don't like the deals I'm seeing in this segment, I'm going to rest or pause there, or even sell off what I have and redeploy it, to your point. We view it as a sign of strength that may create a bit of a complexity discount for folks in the marketplace.

So, we worry about that. And we think, if we can take some of these great-performing businesses, that have real capacity limits, and the online lending business has a capacity limit, as well, within how much can be at this particular portfolio company, how much could be at Prospect's balance sheet itself as a 30% basket asset for consumer -- why not put that into another structure where you can potentially command a higher pure play multiple. Which, of course, is the logic of why a company might examine a spinoff in the first place. So, that's what we are trying to achieve and that's really the first and largest compelling reason.

In addition, when you have a market presence as a significant player -- take CLOs where we're actually the largest investor in the equity tranche of US CLOs, we think, on the planet, and we have a market leadership and we are very, very disciplined. We only work with about a dozen teams out of 150 that are out there in the marketplace, and we've got the ability to do a piece of repeat business with a strong close relationship that's performed strongly with us and for us. To have the available capital under certain capacity constraints to do the next deal, which we still view as attractive on a risk-adjusted basis in the current environment, is important.

So, to have another vehicle, it's able to grow, it's very helpful. It doesn't mean Prospect -- we want to make this very clear -- Prospect, PSEC, is not getting out of the CLO business, it's not getting out of the real estate business, not getting out of the online lending business. We would still have the ability to continue with those.

We got exempted relief for co-investing in February. So, we have the ability to co-invest with any spinco that would pursue a similar strategy. And PSEC may retain a retention of some ownership of such spinco, as well, for a period of time or for a long time, as well.

But that really, Robert, is the biggest, biggest justification to get those pure play multiples. When you look at comps that are pure plays -- and there are pending comps in the online side -- the price to book, I think, of some of those online businesses are like 100x. And we're not saying we're going to trade at 100x right after we spin, but to get even a tiny fraction of that when you're at 1.0x actually discount to that as a BDC industry, then that looks pretty compelling. That's an investment opportunity we want to make available to our shareholders.

Robert, it's John. I have something to add, as well.

We found investing over multiple cycles -- we've been in business now almost 27 years investing over multiple cycles -- we like to have multiple strategies because the CLO business is great now, the online lending business is great now, but if everything changes in the future, that's the one thing that's for sure. So, we like to keep these businesses humming along inside of PSEC, for the optionality to be able to quickly take advantage.

With the spins it's our hope -- no guarantee -- but it's our hope that those trade at multiples that are indicated by their peer group, which are higher multiples than where PSEC trades. And hopefully when people do the analysis of PSEC, they observe that, inside of PSEC is this business which should be at this multiple, this other business which should be at this higher multiple, and that can bring down our cost of capital and bring up our stock price. Robert, all we need is for you to write an enthusiastic research report for that to happen.

I understand, thank you.

The next question comes from Greg Mason of KBW.

Great, thanks guys. First, on the potential REIT spin-out, I assume you'd put your three REITs together. I'm just trying to capture what size would that be. Around $400 million if you put those altogether?

We're still looking at the composition. But likely it would not be all three.

It would likely be American and United. And National would likely be -- we still haven't decided but National would likely be not part of the three because that's where a good chunk of our online assets are held. And we also have some self storage properties within National.

Within the REIT industry, companies tend to be pure play there, as well. So the vast book of our real estate book is multi-family garden-style residential apartments. And we think we have the best chance for multiple expansion if we stick to solely that in the spinco.

There's an opportunity in the future where maybe that is slightly expanded to include analogous areas like student housing and senior living facilities. But self storage probably belongs separate and for that reason we'd keep National, most likely, out of it at this point.

All right. So, those two together get close to $200 million spinning out the CLOs, which is $1 billion. Just thinking about -- so the transaction, so the shareholders would get stock. And does that mean that essentially the book equity of those and the price to book would fall as shareholders get that stock? Is that how the transaction would work? It would essentially be those size of vehicles?

Yes, I guess -- and we said it could be a full spin or a partial spin. That could mean spinning out, in some case, the CLOs all $1.16 billion.

It could mean spinning out a pro rata slice across our approximately 36 deals, and a lesser portion of that. We also have to work out the PSEC retention of such vehicle.

We have to be mindful of what that retention should be from a regulatory standpoint. It's nice to have a capital raise, as well, associated with that so these vehicles perhaps have some dry powder for growth.

A lot of times with IPOs it's good for companies to have three to six months of runway for dry powder to continue to originate rather than have to tap the markets quickly for additional capital. So, there's a lot of different considerations, Greg, but I think the headline here is multiple expansion.

Right. What I was leading to is, ultimately what does that do to the leverage impact? So, if you spin out some of these assets, and you're not getting cash back so essentially the shareholders are getting the stock and the book equity falls, I would assume the debt on your balance sheet is unchanged, so it would seem like you have a rising impact to leverage.

Is there some other movement aspect there? Or how do we think about the leverage impact from the spin-out to PSEC's balance sheet?

As we disclosed, we tend to be leverage neutral. So, any sold assets would get cash back, and then there would be a PSEC retention of the spinco with amounts TBD. But we're not doing something to crank up the leverage ratio at PSEC. I want to make that crystal clear. That is not what our strategy right now anticipates. So, bond holders and rating agencies can relax.

Greg, we're anticipating spinning these off for value, selling new shares, some to PSEC shareholders exercising rights, some to new shareholders coming in. And therefore PSEC receiving value back for what's spun out.

Got it. So, you're actually looking to sell these assets into new vehicles versus just giving shareholders stock in new public companies?

Right. What happens is you get a right to buy this stock and you get the shareholder -- just look up other rights offerings and you'll see how they're done.

I got it, okay. For the new senior loan fund, do you need to do the CLO spin before you're able to effectuate that transaction for your 30% bucket? Or do you have enough capacity to do both the senior loan and still own your CLOs before the spin?

Sorry, can you rephrase your question, Greg. I don't to understand it.

Sure. I would assume the senior loan fund that you're working on, that would be a 30% bucket. And just curious if you're able to do that based on your current utilization of your 30% bucket before the CLOs leave your balance sheet.

Okay, I got you. As we talked about in our last call, our senior loan strategy is quite different from others. We aren't looking to replicate other people's vehicles but to do it much better. And we don't like using the 30% basket for these off balance sheet senior loan funds that people have done.

The returns that folks get off of those are not as good as our CLO business returns. They're not as good as our financial buyout returns The people end up pledging a huge amount of assets in a recourse cross collateralized basis in one place, as opposed to the non-recourse funding.

We think very carefully about risk and basket utilization. Instead what it would involve is selling assets off the balance sheet to one or more investors, and then rotating into a higher yielding strategy while still retaining ball control. And we're not going to the Nth degree of disclosure.

Here is what's happened a lot of times. We come up with an innovation at Prospect and people copy it, by the way. So, we're very mindful not to give all of the crown jewels away on this call. I'm speaking very plainly.

When we did the first convert in this industry in December 2010, people ripped off our documents and copied us after we spent years doing the space work to get the regulatory approval, and ripped it off within three weeks. That's why we'll file things confidentially if we can. Folks will get all the full disclosure at the requisite point on the mechanics.

But I think the most important piece is, do you believe, if you take a CLO business, if you take a real estate business, if you take an online high-growth tech-ish business and put them in a pure play, that it will command a higher multiple than PSEC's multiple today. If you believe that, and that's what we anticipate -- hope and anticipate, can't guarantee of course, but hope and anticipate it would happen -- then this is an outstanding potential move for shareholders. And that's the real logic at the end of the day.

Got it. One final question not related to the spin. You exited AirMall which you owned. It looks like you said you took a $3.5 million realized loss on the exit and a $3 million structuring fee on the exit. Given that you own the whole thing, what was your thought process of taking the structuring fee but realizing a loss versus just exiting it and no significant gain or loss without the structuring fee? Can you just talk about the AirMall exit?

Sure. We did not hire an investment bank to market that asset. Our team at Prospect did an enormous amount of work to source an international buyer, European buyer, for that asset. So, that was a fully earned fee.

Great, I appreciate it.

As well, there's no economic loss there, Greg. Bear in mind, number one, when we look to sell an asset, the choice is hire an investment bank or do it internally.

In this case we chose to devote internal resources. If you ask the people, they would not count the time we spent on that in months but instead in years, particularly with the buyer that had to be spoken to over years.

Number two, the asset -- there was a positive IRR on the investment overall, net of all of the fees. The question when we sell an asset is not, are the people who worked on it going to get paid an M&A fee? Only if magically at the end of the process someone's earned a particular hurdle IRR, you'd have trouble signing people up to work on that, any investment bank, for example, would not work on that basis. So we don't feel, when we take on M&A assignments, that we should.

I would say slight economic loss to shareholders, though, given the 20% incentive fee on the structuring fee versus would be none if the realized loss did not occur. But, yes, I appreciate that.

Greg, for me, as an investor, I look at economic return -- did I make money on the investment. And I understand the way these things are accounted for is dictated by regulatory and other.

But to me, number one, it is the economics that drives everything else. And, number two, we can't devote resources to M&A activities and wait until the last second to see if we've hit some hurdle return in order to justify devoting those resources.

Great, thanks, John. I appreciate it.

Our next question is a follow-up from John Bach at Wells Fargo.

Thank you. Just one quick follow-up. John, you mentioned the word -- rights offering. And I just want to try to make sure I understand this. The way it would happen is you would offer -- well, actually, just imagine I don't know anything about --.

John Bach, let me help you here. Number one -- I had three things I wanted to comment on that you asked about and I couldn't get a word in edgewise.

Number one, there are many methods, strategies, structures for spinning off assets to shareholders. We haven't decided definitively on one. I use the word -- rights offering -- globally. That's not any specific -- I don't have any specific structure that I can convey to you right now.

So, were I to attempt to describe the mechanics of how we intend to spin these assets off to shareholders on a leverage-neutral basis, I'd be getting out ahead of myself. I don't want to pretend that I have an architect's plan that has every little detail in it because it turns out, for a company like ours, spinning assets off to shareholders and achieving leverage neutrality and NAV neutrality, which is our objective, and also unlocking value for shareholders, involves far more complexity than we're able to convey on this phone call. And I apologize for not being able to do it. It would really take days. Part of it's still being worked out.

Let me go to the other thing. In the CLO business, to date we have had excellent results. That's not a guarantee that those will continue on ad infinitum forever. They could change the CLO business. The markets, the spread can all change.

But, as Grier mentioned, we set the arbitrage when we invest, we have the call right, being the biggest in the business, being able to in effect throw our weight around, invest with great managers on terms that we like. And, as a result, we have been able to maintain high positive returns on the entire fleet to date. No guarantee that will go on forever just as it has but we do like the business based on historic results.

Lastly, on our cost of capital, you do need to recognize that when we sell a share of stock at a dividend yield that we're not happy with, that we're working hard to get down -- and I think Grier put his finger on this complexity discount -- and we want to turn that around to our benefit where people say -- wow several exciting businesses in there. Now they are being valued separately. The parts add up to more than the whole. We would like to get our cost of capital down.

We don't want to stand in place and wait for that to happen. We have to keep moving all these businesses forward. But we don't have anything to show to shareholders.

But you need to calculate when a dollar of stock frees up a dollar of capacity in our credit facility, you have to give credit for that. You can't just say -- oh, the marginal cost of capital is a dividend on the stock. That's only half the equation. I understand you know that, but somehow that seems to be getting lost in the discussion.

I appreciate it. We can follow-up with the cost of capital argument off line. The only thing I want to make sure is correct is, in terms of the spin-out, John, as you think of all of the shareholders, there would be no net NAV dilution at all on a per share basis?

John, you're on our wavelength. We believe we have several routes to achieve that. And we haven't yet decided exactly which one we're going to take.

There's some work to be done. I can't whitewash the fact that we're not finished doing the work,

But, at the end of the day, it's our intention, and we believe we can achieve it, to have the spin-outs put value in the hands of shareholders at a higher per share valuation mark than where they are now -- A; B -- be NAV neutral; And, C, be leverage neutral.

When we have got all the jigsaw pieces fitting together in the puzzle -- we have a few, but not all -- we will be ready for primetime and you will be one of the first to see it. I know you'll be watching your computer for the instant update.

Always am following this like I do fantasy football. Thank you so much, guys. I appreciate it.

Our next question is a follow-up from Terry Ma of Barclays.

Hi, guys. Just one follow-up on the spinoff. As you move, let's call it, like $1.6 billion of assets off the balance sheet, how are you guys thinking about core earnings and also dividend policy? Will you look to reset the dividend?

I'm sorry, where did you get $1.6 billion?

Just ballpark figure, assuming you spin off the CLOs and about $400 million in real estate?

As I said before, any assets sold from the balance sheet, the desire is PSEC would get cash for those. And the rest would be retention, If PSEC retained an ownership of spinco, then PSEC is getting its pro rata distributions from spinco, similar to what's happening today.

So the goal is to be leverage neutral, earnings neutral, and NAV neutral. But what you've created then is entities that can be valued hopefully much greater as pure plays.

Entities then that have the ability to expand their own capitalization prudently and accretively time to fund the respective growth. And that don't have tight regulatory basket limits in different structures, because the BDC balance sheet is okay for CLOs, it's okay for consumer lending, but it's really held back by 30% basket, and in some cases leverage restrictions for each of those. So, much better to be as a pure play, if you really want to grow it, in a different vehicle altogether.

And then real estate doesn't necessarily have significant structural limitations as a BDC. But, again, if you look at the valuation of REITs on a cap rate basis, on a dividend yield basis, arguably REITs have just done much better from a yield total return standpoint than BDCs have done over the last few years. And, so, we can tap into that benefit, as well.

Got it. Thanks.

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

I think we're all set. Have a wonderful lunch, everybody.

Thanks, all.

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