Prospect Capital Corp (PSEC) 2017 Q4 法說會逐字稿

Good morning, and welcome to the Prospect Capital Corporation Fiscal Year Earnings Release and Conference Call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to John Barry, Prospect Capital's Chairman and CEO. Please go ahead.

Thank you, Anita. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Brian Oswald, our Chief Financial Officer. Brian?

Thanks, John. This call is the property of Prospect Capital Corporation. Unauthorized use is prohibited. This call contains forward-looking statements within the meaning of the securities laws that are intended to be subject to safe harbor protection. Actual outcomes and results could differ materially from those forecast due to the impact of many factors. We do not undertake to update our forward-looking statements unless required by law. For additional disclosure, see our earnings press release, our 10-K and our corporate presentation 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, Brian. Before we begin today, each of us at Prospect is thinking about our portfolio company employees, shareholders, family members, friends and people anywhere suffering from the devastation of Hurricane Harvey over recent and coming days. We pray for a speedy recovery.

For the June 2017 fiscal quarter, our net investment income or NII was $69.7 million or $0.19 per share, down $0.01 from the prior quarter, carrying out our plan to reduce risk, decrease originations, structuring fees and management fees. Executing our plan to preserve capital, reduce risk and avoid chasing yield through investments presenting a weak risk/reward profile at this point in the economic cycle, we reduced originations this quarter to about half the levels of the prior quarter. We remain committed to our historic credit discipline.

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credit quality and yield. We believe our disciplined approach to credit will serve us well in the coming years, just as that disciplined approach has served us well over multiple credit cycles.

In the June 2017 quarter, we also reduced risk by decreasing our net debt-to-equity ratio from 75.6% at March 2017 to 70.5% at June 2017.

Our net income was $51.2 million or $0.14 per share, up $0.09 from the prior quarter due to lower management fees and reversals of unrealized depreciation in our energy, consumer finance and structured credit investments in the June 2017 quarter compared to the March 2017 quarter.

For the fiscal year ended June 2017, our net investment income was $306.1 million or $0.85 per share, down $0.19 from the prior year. Our net income was $252.9 million or $0.70 per share, up $0.41 from the prior year. We are pursuing multiple strategies to enhance our income over the coming years.

On the asset management side, we are processing a robust pipeline of new originations; enhancing cash flows in our structured credit portfolio through extensions, refinancings and calls; optimizing NPRC's online lending business through securitizations and refinancings

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multifamily real estate portfolio; improving controlled investment operating performance; and enhancing yields through higher floating-rate, LIBOR-based rates.

On the liability management side, we plan on continuing ways to lower our cost of capital through a combination of increased revolver utilization and lower-coupon new term issuance.

We are announcing monthly cash distributions to shareholders of $0.06 per share for September and October 2017, marking 111 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in November.

Since our IPO 13 years ago through our October 2017 distribution, at our current share count, we will have paid out $16.07 per share to original shareholders, exceeding $2.3 billion in cumulative distribution to all shareholders. Our NAV stood at $9.32 per share in June 2017, down $0.11 from the prior quarter.

Our balance sheet as of June 30, 2017, consisted of 90.4% floating-rate interest-earning assets and 99.9% fixed-rate liabilities, positioning us to benefit from rate increases. Our recurring income, as measured by our percentage of total investment income from interest income, was 96.3% in the June 2017 quarter, further reducing the contribution of onetime structuring fees in favor of recurring interest income.

We believe there is no greater alignment between management and shareholders than for management to purchase a significant amount of stock, particularly when management has purchased stock on a same basis as other shareholders in the open market. Prospect management is the largest shareholder in Prospect and has never sold a share. Management, on a combined basis, has purchased at cost over $175 million of stock in Prospect, including over $100 million of stock since December 2015.

Our management team has lived in the investment business for decades, with experience navigating both challenges and opportunities presented by dynamic economic and interest rate cycles. We have learned when it's more productive to reduce risk than to reach for yield. The current environment is one of those times. We believe the future will provide us with attractive opportunities to purchase income-earning assets, utilizing the dry powder we have built and reserved for that purpose.

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

Thanks, John. Our scaled business, with over $6 billion of assets and undrawn credit, continues to deliver solid performance. Our experienced team consists of approximately 100 professionals, representing one of the largest middle-market credit groups in the industry.

With our scale, longevity, experience and deep bench, we continue to focus on a diversified investment strategy that covers third-party private equity sponsor-related and direct non-sponsor lending, Prospect-sponsored operating and financial buyouts, structured credit, real estate yield investing and online lending.

As of June 2017, our controlled investments at fair value stood at 32.7% of our portfolio. This diversity allows us to source a broad range and high volume of opportunities, then select, in a disciplined bottoms-up manner, the opportunities we deem to be the most attractive on a risk-adjusted basis. Our team typically evaluates thousands of opportunities annually and invests, in a disciplined manner, in a low single-digit percentage of such opportunities. Our nonbank 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 2017, our portfolio at fair value comprised 48.3% secured first lien, 19.1% secured second lien, 18.5% structured credit with underlying secured first-lien loan collateral, 0.1% small business whole loans, 0.8% unsecured debt and 13.2% equity investment, resulting in 86% 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 12.2% as of June 2017, down 0.1% from the prior quarter due to continued asset spread compression in the market. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generate distributions. We have continued to prioritize first-lien senior and secured debt with our originations to protect against downside risk while still achieving above-market yields through credit selection discipline and a differentiated origination approach.

As of June 2017, we held 121 portfolio companies with a fair value of $5.84 billion. We also continue to invest, in a diversified fashion, across many different portfolio company industries with no significant industry concentration. The largest is 10.7%. As of June 2017, our asset concentration in the energy industry stood at 2.4%, including our first-lien senior secured loans, where third parties bear first loss capital risk.

Non-accruals as a percentage of total assets, excluding one investment which timely paid our income-producing contractual interests in the June 2017 quarter, stood at approximately 1.2% in June 2017, down 0.2% from the prior quarter, with approximately 0.2% residing in the energy industry. Our weighted average portfolio net leverage stood at 4.19x EBITDA, up slightly from 4.15x the prior quarter. Our weighted average EBITDA per portfolio company stood at $48.3 million in June 2017, down from $49.4 million in March 2017.

The majority of our portfolio consists of sole-agented and self-originated middle-market loans. In recent years, we have perceived the risk-adjusted reward to be higher for agented, self-originated and anchor investor opportunities compared to the non-anchor broadly syndicated market, causing us to prioritize our proactive sourcing efforts.

Our differentiated call center initiative continues to drive proprietary deal flow for our business. Originations in the June 2017 quarter aggregated $223 million, down from $450 million in the prior quarter. We also experienced $352 million of repayments and exits as a validation of our capital preservation objective, up from $303 million in the prior quarter, resulting in net repayments of $129 million compared to net originations of $147 million in the prior quarter.

During the June 2017 quarter, our originations comprised 32% structured credit; 31% third-party sponsor deals; 31% syndicated debt, including early look anchoring investments and club investments; 4% online lending; 1% real estate; and 1% operating buyouts. To date, we've made multiple investments in the real estate arena through our private REITs, largely focused on multifamily stabilized yield acquisitions with attractive 10-year financing.

In the June 2016 quarter, we consolidated our REITs into NPRC. NPRC's real estate portfolio has benefited from rising rents, strong occupancies, high-returning value-added renovation programs and attractive financing recapitalization, resulting in an increase in cash yields as a validation of this income growth business, alongside our corporate credit businesses. NPRC has exited completely certain properties, including Vista, Abbington, Bexley and Mission Gate, with an objective to redeploy capital into new property acquisitions. We expect both recapitalizations and exits to continue. NPRC also, in the past year, closed its first portfolio investment in student housing, an attractive segment similar to multifamily residential, where we have analyzed many opportunities for several years.

In addition to NPRC's significant real estate asset portfolio, over the past few years, NPRC and we have grown our online lending portfolio with a focus on super-prime, prime and near-prime consumer and small business borrowers. This online business, which includes attractive advance-rate financing for certain assets, is currently delivering a more than 12% annualized return, net of all costs and expected losses.

In the past 4 years, we and NPRC have closed 5 bank credit facilities and 3 securitizations, including, in the June 2017 quarter, NPRC's second consumer securitization to support the online business, with more securitizations expected in the future. NPRC is focused on expanding its most productive online lending platform activity while refinancing and redeploying capital from other online platforms.

Our structured credit business performance has exceeded our underwriting expectations, demonstrating the benefits of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities.

As of June 2017, we held $1.1 billion across 43 nonrecourse structured credit investments. The underlying structured credit portfolios comprised around 2,500 loans and a total asset base of over $19 billion. As of June 2017, our structured credit portfolio experienced a trailing 12-month default rate of 75 basis points, a decline of 30 basis points from the prior quarter and 79 basis points less than the broadly syndicated market default rate of 154 basis points. This 79 basis point outperformance was up from 44 basis point outperformance in the June -- in the March 2017 quarter.

In the June 2017 quarter, this structured credit portfolio generated an annualized cash yield of 18.8%, up 0.9% from the prior quarter, and a GAAP yield of 13.6%, stable with the prior quarter.

As of June 2017, our existing structured credit portfolio has generated $939 million in cumulative cash distributions to us, representing 64% of our original investment. Through June 2017, we've also exited 7 investments totaling $154 million with an average realized IRR of 16.8% and a cash-on-cash multiple of 1.42x.

Our 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 the majority holder, we control the ability to call a transaction in our sole discretion in the future, and we believe such options add substantial value to our portfolio. We have the option of waiting years to call a transaction in an optimal fashion rather than when loan asset valuations might be temporarily low. We, as majority investor, can refinance liabilities on more advantageous terms, remove bond baskets in exchange for better terms from debt investors in the deal and extend or reset the investment period to enhance value. Our structured credit equity portfolio has paid us an average 21.4% cash yield in the last 12 months.

So far, in the current September 2017 quarter, we've booked $42 million in originations and received repayments of $142 million, resulting in net repayments of $100 million. Our originations have comprised 43% syndicated and club debt, 38% online lending, 12% third-party sponsor deals and 7% real estate.

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

Thanks, Grier. We believe our prudent leverage, diversified access to matched-book funding, substantial majority of unencumbered assets and weighting towards unsecured fixed-rate debt demonstrate both balance sheet strength as well as substantial liquidity to capitalize on attractive opportunities.

Our company has locked in a ladder of fixed-rate liabilities extending over 25 years into the future, while the significant majority of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise.

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 an institutional bond, acquire another BDC, along with many other 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 our balance sheet.

As of June 2017, we had approximately $4.6 billion of our assets as unencumbered assets, representing approximately 74% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, which has a AA-rated $885 million revolver with 21 banks and with a $1.5 billion total size accordion feature at our option. The revolver is priced at LIBOR plus 225 basis points and revolves until March 2019, followed by a 1-year amortization period, 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 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 and investment-grade BBB minus rating from S&P. We've now tapped the unsecured term debt market on multiple occasions to ladder our maturities and extend our liability duration more than 25 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we substantially reduced our counterparty risk over the years.

We have refinanced 3 nonprogram term debt maturities in the past 3 years, including our $100 million baby bond in May 2015, our $150 million convertible note in December 2015 and our $167.5 million convertible note in August 2016. In the June 2017 quarter, we issued a 4.95% $225 million convertible bond, utilizing a substantial amount of the proceeds to repurchase bonds maturing in the upcoming year. We have also called $139 million of our program notes maturing through September 2019.

For the remainder of calendar year 2017, we have liability maturities of $61 million. Our $885 million revolver is currently undrawn. If the need should arise to decrease our leverage ratio, we believe we could slow originations and allow repayments and exits to come in during the ordinary course, as we demonstrated in the first half of the calendar year 2016, during market volatility.

We now have 8 separate unsecured debt issuances aggregating $1.7 billion, not including our program notes, with maturities ranging from October 2017 to June 2024. As of June 30, 2017, we had $981 million of program notes outstanding with staggered maturities through October 2043.

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

Thank you very much, Brian. We can now take questions.

(Operator Instructions) The first question comes from Christopher Testa with National Securities Corporation.

I'd just like to start off on the non-accruals. So United Sporting was a new one this quarter. Last quarter, you had marked at 94, and it dropped to 59, which is pretty rapid of a decline there in the value. Just curious if you can provide some color on that situation.

Sure. Thank you, Christopher. I think Grier would like to talk about United Sporting because he's very familiar with that.

Sure. Thanks for your question, Chris. So 2 items, overall, that's really impacting that business, one of which is I would describe as a cyclical one, which is when there's elections that go a certain way, there tends to be a slowdown in sales to the firearms sector for the first 6 or 9 months or so, and then there's more of a normalization thereafter. That's what we've observed studying data over long periods of time. But I think in terms of the short-term [faster] that you referenced, there was a bankruptcy in the retail space -- a major customer, Gander Mountain, where there are some credit losses, hopefully onetime in nature, where other types of customers, including independents, that don't suffer as much from an online threat in this particular segment, for regulatory background check clearance reasons, is really not an online business in -- for a lot of it -- that hopefully that will pick up the slack. So we shall see. We have a very strict non-accrual policy, which means that we can sometimes put assets on non-accrual even if they are still paying us. And for clarity, non-accrual does not mean no income recognition. Non-accrual means you recognize income as you receive payments, and that's subject to further testing as well, but you're not accruing income in between periods. So technically, this is a non-accrual. We wanted to highlight it's a paying non-accrual as opposed to a nonpaying non-accrual. Hopefully, that helps to answer your question, Chris.

Yes. No, it does. But if it's still paying you, I'm just curious why it's marked under 60.

Well, the company's experienced some short-term stress pertaining to the Gander bankruptcy, which severely impacted earnings short term for the reasons I just talked about. We're hoping to see recovery out of that asset.

Okay. And just kind of moving on with the non-accruals. If I look at Edmentum, I know you have that -- the unsecured PIK note on non-accrual. The 2 tranches in front of it are marked kind of at fair value. Just curious, in that structure, how much first-lien debt is senior to you to the extent that you're able to disclose that?

I don't have that at my fingertips right now, Chris, and we'd have to check and see what we're able to disclose. And we are subject to confidentiality with these private companies, so we can't always disclose every last thing about the companies we're invested in. So we'll have to check that. That's a club deal. We're one of multiple lenders in the education space. A new chief executive officer was just hired for that company that the lender/equity group is very excited about. There does tend to be an annual sales cycle aspect that has just wrapped up, so the impact of new leadership would likely not occur until the sales cycle of the following year in calendar year 2018, commensurate with the 2018-2019 school year.

Got it. And of the non-accruals exited during the quarter that are no longer on non-accrual, whether it was structured or sold, that you have realized -- unrealized, excuse me, losses of $68.3 million, the realized losses during the quarter roughly $97 million. Just what made up the difference? Was there one non-accrual restructured significantly below the mark that you had it out? Was there something else that occurred? Just any color there is appreciated.

Really, the biggest part of that realization that you referenced was a company called Gulf Coast Gulfco, which is a company that we took over several years ago, a forging business serving the oil and gas industry, and worked very hard. We basically had people on site at the company -- in many cases multiple people, virtually every business day since taking over ownership, trying to rehabilitate the business. And what we concluded about that business -- it was based on the fixed cost structure of the business and the kind of new paradigm for the oil and gas industry and the new margin reality. We did not see a viable path to recovery in any sort of investable future, so we took the prudent path and sold the asset to a strategic that could capture synergies that we could not on a stand-alone basis. So obviously not an outcome that we had targeted, but really a casualty of the significant falloff in the oil and gas industry that has been the primary credit event since 2014 impacting us -- luckily, not as much as perhaps others. And John, anything you'd want to add to that?

Well, just that -- I don't know how much I can add to what you've just said other than to say these loans where we end up in a restructuring situation, sometimes can turn around and provide an equity return and one that, Chris, I'm surprised you haven't asked about since you seem very on top of Edmentum, USC, Gulfco. I'm quite impressed. There's a fourth one in there where I am personally hopeful for an equity upside in a restructured deal. So that's what I have to add there, Grier. Anything else, Chris, from you?

Yes, just last one for me, and then I'll hop back in the queue here. Just looking at the structured credit, obviously, yields are, across the board, under pressure from the reinvestment environment being challenging. Just curious, do you have a certain percentage of your book, based on a vintage basis, that you're able to call each quarter, a certain number of deals or refinance them? And to the extent that you're able to do that, are you guys of the mindset now that it's best to refinance everything you can? Or are you waiting for a potential further spread compression where you might get even better refi terms on the CLOs in the coming quarters?

Well, Chris, that's another great question. What we've done is examine -- because we are the majority owner of the equity of the PSEC CLOs, we have the right to call, the right to redeem, the right to repack, the right to reset -- -- many rights that we find provide significant option value to us in a dynamic rate environment. I think everyone knows what I mean by a dynamic rate environment these days, with a wall of money, really new money managed by people with limited experience in our marketplace. With that wall of money coming into our marketplace, we have seen significant spread compression, significant yield compression across the board. And the last time this happened, it was also the result of new money coming into our market in 2006. Many of those new money credit managers trying their hand at credit for the first time are no longer in business. Would that happen now? We'll see. We intend to stay in business, obviously. In the CLO business, the spread compression and yield compression has been as evident as anywhere else. And I know, Chris, you're aware of this, but just to state the obvious, borrowers can refi. Borrowers can just go to a lender and say, "Well, I'm going to refi. I'm getting all these calls from brand-new competitors of Prospect. I'm hearing I can reduce interest rates on my loans by 100 basis points tomorrow. So why don't you just agree now to reduce interest rate on the existing loan, and we can save both parties a lot of friction?" So it's that easy. In our CLO book, which is hundreds, I guess maybe thousands of loans, that process continues apace. What can we do? We can reprice, reset, repack, refi the liabilities, which we have been doing. Because we own the majority positions in our CLOs, we are able to look at every single one and examine whether we should refi, reset, repack, call and the like. And I'm sure, Chris, since you seem very on top of this, that you've seen what we've been doing. I would say that we -- well, I can say we have examined every single CLO in the book to see what is the best optimizing strategy. In some cases, it's a reset. In some cases, it's a refi. In some cases, it's a redemption or call. So it varies from CLO to CLO. I'm sure, as you're aware, that -- I'm sure you're aware that there are restrictions in the Dodd-Frank risk retention rules that limit how many refis you can do, the time period during which you can refi. And the result of that is it would -- generally, one of the trickiest questions is, first, when is the last -- can we refi this? Is it one of the CLOs that can be refied? And if so, what is the deadline for doing that? And once we know what the deadline is, we then have to ask ourselves, what do we think is going to happen with spreads and interest rates? Now as Keynes said, there's 2 opinions on interest rates: one coming from people who don't know where interest rates are going and the other coming from people who don't know that they don't know where interest rates are going. So we have no more ability than John Maynard Keynes to predict interest rates, except for one thing. We can look at the calendar. And when we look at the calendar, we can see how many issuers -- CLO reset issuers, are trying to squeeze through a particular window. And if it's too many at one time, we know that the pace will be slower and that we may not be able to pick the exact day. And then we get into the deadline problem. We don't want to pass the deadline for doing this, whether it's in the documents or as part of Dodd-Frank. For example, Dodd-Frank has a provision in there, in the law, in the regs, that allows one refi prior to, I forget what it is, December 2017. And you want to choose the optimal time when you will refi prior to that deadline date. And another factor that you're going to be considering is how big is the CLO, how much money will it draw from the marketplace, what is the duration. If you've got one that has 6 years to go and another that has 6 months to go, you are going to not waste your refi bullets on the 6-month CLO, but instead, you're going to refi the 6-year CLO. Well, that would be true if each had the same cost of capital. Well, what if the longer-duration CLO has a lower cost of capital than the shorter-duration CLO? Now you have to think, oh, what is the bang for the buck doing A versus B? So those are the kinds of analyses we go through. I think your question was, have we examined every single one, and we have. I don't have the exact numbers of how many. Maybe Brian does. I gave them out on the last earnings call, and the numbers have changed -- how many we've reset, how many we've refied, how many we've repacked, how many we've called, how many we've redeemed. Brian, do you have those numbers? Grier, do you have them here?

While Brian's looking that up, I want to make sure we -- I answer Chris' specific question, which I thought was, how do you decide if you want to do the refi now as opposed to x number of months from now? And the answer, Chris, is we do a matrix where we show what the IRRs are going to be of each time period, with a reasonable band of assumptions about the future. And we try to pick the time period that's going to optimize the IRR. But there's now a new overlay on top of that, Chris, which is we want to make sure -- in a structured credit business, CLO business, you want to make sure you don't have your option truncated when collateral values are low, which is a long way of saying, you don't want have a deal ending when a recession is just starting or in the middle of recession. So we have a stronger bias toward extensions and calls into new deals, which are kind of de facto extensions as you use a lot of the same collateral because -- then we're really extending the maturity of the overall deal. And we're -- I've heard it's pole-vaulting over the next recession. So you have locked in liabilities, and you're benefiting substantially from enhanced volatility and, therefore, option value. So it's a pretty complex analysis but shows how active management this book really is.

Got it. And I missed the (inaudible) you guys usually say. What were the cash and gap yields on the CLO book this quarter, Grier?

Sure. We have it in our release. It's 13.6% on the gap side. And the cash side was about, I have it right here, 18.8%. So the gap yield is actually pretty stable, Chris, and shows you've had continued spread compression that has been compensated virtually equally by the benefit of reducing our liability costs and also lowering of discount rates for this paper. It's become more challenging to find high-returning paper, but we've been, really, in a reinvestment mode as opposed to a grow-the-book mode for this business within PSEC, anyways. But the team is seeing, so far, spread stabilization in the broadly syndicated market. I would say that is not the case in the middle market, where more money continues to pour in from the private institution marketplace and into that side, which has led us to spend a lot more time on smaller deals, on non-sponsor deals and on saying, look, sometimes you have to accept spread compression to stay in a [one-off] spot as opposed to chase higher-risk junior debt situations or over-leverage situations, which is really part and parcel of what John was talking about at the beginning of the call with risk management and proper underwriting and not chasing irrational deals that we're seeing done in the marketplace, particularly here in 2017.

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

All right. Well, thank you, everyone, and have a wonderful afternoon. Bye now.

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