Prospect Capital Corp (PSEC) 2018 Q1 法說會逐字稿

Good morning, and 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, Kate. Joining me on the call this morning 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-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. For the September 2017 fiscal quarter, our net investment income or NII was $63.7 million or $0.18 per share, down $0.01 from the prior quarter and equal to our current dividend. Executing our plan to preserve capital, reduce risk and avoid chasing yield through investments deemed too risky with poor risk return profiles at this point in the cycle. We booked originations this quarter in line with the prior quarter. We remain committed to our historic credit discipline. We currently have a robust pipeline of potential investments in our target range for credit quality and yield. We believe our disciplined approach to credit will service well in the coming years, just as that disciplined approach has served us well in past years.

In the September quarter, we maintained -- actually reduced to 71.6% our net debt to equity ratio, down 200 basis points from a year ago. Our net income was $2 million (sic) [$11.973 million] or $0.03 per share, down $0.11 from the prior quarter due to unrealized depreciation within our structured credit investments and a lower interest-earning asset base in the September quarter over the June quarter. We are working to execute on a robust pipeline of new originations, improving cash flows in our structured credit portfolio, including through extensions, refinancings, calls and re-packs, optimizing NPRCs, online lending business, including through securitizations and refinancings, increasing realizations in NPRC's multifamily real estate portfolio, improving controlled investment operating performance and enhancing yields to higher floating rate, LIBOR-based rates.

On the liability management side, we plan on lowering our weighted average 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 November, December and January, representing 114 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in February.

Since our IPO 13 years ago through January 2018 distribution, at our current share count, we will have paid out $16.26 per share to original shareholders, exceeding $2.4 billion in cumulative distributions to all shareholders. Our NAV stood at $9.12 per share in September, down $0.20 from the prior quarter.

Our balance sheet as of September 30 consisted of 90.45% 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 93% in September quarter. We believe there is no greater alignment between management and shareholders than for management to purchase and own over long periods of time a significant amount of company's stock, especially when management has purchased that stock on the same basis as other shareholders in the open market and not with the benefit of option.

Prospect management is the largest shareholder in Prospect and has never sold a share. Management, on a combined basis, has purchased cost more than $175 million of stock in Prospect, including over $100 million since December 2015. Our management team has been in the investment business for decades, with experience handling both challenges and opportunities served up by dynamic, economic and interest rate cycles. We have learned when it is more productive to reduce risk and to reach for yield. And we believe the current environment is one of those time periods. At the same time, we believe the future will provide us with substantial opportunities to purchase attractive assets, utilizing the dry powder we have built and reserved . Thank you. I'll now turn the call over to Grier.

Thank you, John. Our scaled business, with around $6 billion of assets and undrawn credit, continues to deliver solid performance. Our experienced team consists of approximately 100 professionals, representing 1 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 nonsponsor lending, Prospect-sponsored operating and financial buyouts, structured credit, real estate yield investing and online lending.

As of September 2017, our controlled investments at fair value stood at 34% of our portfolio. This diversity allows us to source a broad range and high volume of opportunities, then select at a disciplined bottoms-up manner, the opportunities we deemed 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 the preference for secured lending and senior loans.

As of September 2017, our portfolio at fair value comprised 48.5% secured first lien, 19.5% secured second lien, 17.0% structured credit with underlying secured first lien collateral, 0.1% small business whole loans, 0.8% (sic) [0.6%] unsecured debt and 14.3% equity investments, resulting in around 85% of our investments being assets with underlying secured debt benefiting from borrower-pledged collateral.

Prospect's approach is 1 that generates attractive risk-adjusted yields, and our performing debt investments were generating an annualized yield of 11.8% as of September 2017, down 40 basis points 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've continued to prioritize first lien senior unsecured debt with our originations to protect against downside risk while still achieving above-market yields through credit selection discipline and a differentiated origination approach.

As of September 2017, we held 120 portfolio companies with a fair value of $5.69 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration, the largest is 11.2%. As of September 2017, our asset concentration in the energy industries stood at 2.7% and our concentration in the retail industry stood at 0%. Nonaccruals as a percentage of total assets stood at approximately 2.1% in September 2017, down 40 basis points in the prior quarter. Our weighted average portfolio net leverage stood at 4.32x EBITDA, up from 4.19x the prior quarter. Our weighted average EBITDA per portfolio company stood at $49.2 million in September 2017, up from $48.3 million in June 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 nonachor 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 September 2017 quarter aggregated $222 million nearly the same as $223 million in the prior quarter. We also experienced [$258 million] of repayments and exits as a validation of our capital preservation objective, resulting in net repayments of [$35 million].

During the September 2017 quarter, our originations comprised 47% agented sponsor debt, 34% nonagented debt including early look anchoring and club investments, 17% online lending and 2% real estate. 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 a nd attractive financing recapitalizations, 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, this most recent quarter with an objective to redeploy capital into new property acquisitions, as we've been doing in the quarter to-date. We expect both recapitalizations and exits to continue and NPRC has multiple exits pending with attractive expected realized returns. NPRC has recently (inaudible) and closed 2 acquisitions with the Repeat Property Management relationship with a strong track record with more acquisitions expected.

In addition to NPRC 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 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 at the end of the June 2017 quarter, NPRC's second consumer securitization to support the online business. NPRC is currently working on its third consumer securitization as well as the recapitalization of multiplatform assets. 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 initial 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 September 2017, we held $1.0 billion across 43 nonrecourse structured credit investments. The underlying structured credit portfolios comprised over 2300 loans and a total asset base of over $19 billion. As of September 2017, our structured credit portfolio experienced a trailing 12-month default rate of 55 basis points, a decline of 20 basis points in the prior quarter and 98 basis points less than the broadly syndicated market default rate of 153 basis points. This 98 basis points outperformance was up from 79 basis points in the June 2017 quarter. In the September 2017 quarter, this portfolio generated an annualized cash yield of 18.3%, down 50 basis points in the prior quarter and a GAAP yield of 12.4%, down 120 basis points in the prior quarter. As of September 2017, our existing structured credit portfolio has generated a $1 billion in cumulative cash distributions to us, representing 70% of our original investment.

Through September, 2017 we've also exited 11 investments, totaling $291 million with an average realized IRR of 16.3% and cash on cash multiple of 1.49x.

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 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, also known as reset the investment period to enhance value. Our structured credit equity portfolio has paid us an average 20.5% cash yield in the 12 months ended September 30, 2017.

So far in the current December 2017 quarter, we have booked $126 million in originations and received 0 repayments, resulting in net originations of $126 million. Our originations have comprised 59% nonagented debt, 32% real estate, 6% agented sponsor debt and 3% operating buyouts.

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.

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 September 2017, we held approximately $4.5 billion of our assets as unencumbered assets, representing 75% 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 1 year of amortization with interest distributions continuing to be allowed to us. Outside of our revolver and benefiting from our unencumbered assets, we have 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, no cross defaults with our revolver.

We enjoy an investment grade rating of BBB+ from Kroll and investment grade BBB- rating from S&P, which was recently reaffirmed. We've now tapped the unsecured debt market on multiple occasions to ladder our maturities and to 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've substantially reduced our counterparty risk over the years.

We refinanced 4 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, our $167.5 million convertible note in August 2016, and our $50.7 million convertible note in October 2017, the latter of which we had also significantly repurchased in the June 2017 quarter.

In the June 2017 quarter, we issued 4.95% $225 million July 2022 convertible bond, utilizing a substantial amount of proceeds to repurchase bonds maturing in the upcoming year. We have also called $222 million of our program notes maturing through November 2019. For the remainder of calendar year 2017, we have a liability maturities of $61 million. Our $885 million revolver is currently undrawn. If the need to 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 the first half of calendar year 2016 during market volatility.

We now have 7 separate unsecured debt issuances aggregating $1.7 billion, not including our program notes, but maturities ranging from March 2018 to June 2024. As of September 30, 2017, we had $916 million of program notes outstanding with staggered maturities through October 2043.

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

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

(Operator Instructions) The first question comes from Leslie Vandegrift of Raymond James.

Just a quick question on the market. We saw the markdowns on the structured credit which you mentioned in the comments. Just wanted to get a bit more color there and where you see that going this quarter and into 2018.

Sure, Leslie. Thank you for that excellent question. It's difficult to tell sitting here in November 9 what state of play will be from a valuation perspective on December 31, which is 7 weeks from now. But in general, the quarter that just [wrapped up] the factor of asset spread compression outweighed as a negative factor on the valuation front, positive factors including an increase in LIBOR, an increase in -- rather a reduction in trailing- 12 month default rates in which we significantly outperformed the market, and in general, a reduction in discount rates for this type of paper, these securities. There's a lot of capital up there, chasing floating rate right now. And that's true not just in the broadly syndicated market, but also the core middle market business impacting a lot of people in the industry right now, which is why we're being ultra cautious and you've seen us not stomp on the gas pedal for new originations we're [passing] at a lot of deals right now. But within structured credit, it's difficult to tell if asset spread compression will continue. Some of it is being enabled by in the structured credit business, a reduction in liability spreads. So it's a question is, what point do you had a floor for what say AAA investors will expect to get paid as a spread that impacts then, how much arbitrage is available on the asset side of the ledger.

As we talked about historically in CLOs and structured credit, your 2 general risks are times being too good and times being too bad. Too good means the time of declining spreads. Too bad means the time of spiking default rates. The latter generally is worse than the former. We're in the former range right now, times being too good. But we do have benefit in that many loans are trading at a premium to par right now or robustly valued on an underlying basis. And we do have the ability, if spread compression worsens, to call deals, and to call at favorable prices and to take that capital and redeploy into other places. We are very, very cautious not just on the valuation front, but also -- which is 100% third party driven, but also on income recognition which I think is an important point that's oftentimes lost in the picture. And that was the reason for some pressure on the income side of things with the reduction in net investment income yield in the quarter. Notice that the recognized GAAP net investment income driving yield for structured credit was significantly below our cash yield. That means, we are conservatively taking a significant portion of our cash proceeds, about 1/3, and utilizing that to reduce our cost basis.

And that's about 500 basis points less in income recognition that others are doing in the marketplace, as a highly conservative accounting focus within our structured credit business. Only about 2/3 of every dollar of cash we receive is recognized as income, the other 1/3 goes to reduce our cost base; that's also of course a storehouse and piggybank, our protection for the future as well. Any follow up question there Leslie?

Yes, just 1 on that, so if -- being a bit more conservative on that side right now, but you also mentioned in the prepared remarks, 34% the portfolio is now on the controlled side. Just kind of with those issues right now in CLOs, whether -- because it's too good or whatever it is in the cycle, are you going to focus on doing more of the like online lending, more of the traditional controlled companies on your portfolio, where's the other route there?

We've been in a low 30s and kind of the controlled investment side for a while now. That does not include the CLO business. The structured credit business actually declined to about 17% of our book in part through write-down and part through not making much in a way significant new investments in that business, and 1 chunk of that control piece, the biggest singular chunk is NPRC , a majority of which is a real estate business. Real estate business has arguably been 1 of our best performing businesses recently, a real bright spot, and we're quite pleased with the performance of the business. We've generated something -- we meaning NPRC has generated something like 30% realized internal rate of return on exited deals that have gone the distance. And as we mentioned in our prepared remarks, we've got other exits as well. We're constantly evaluating the hold, sell and of course purchase new properties optimization, and we're putting the properties we deem important to do so where we've already captured the value from a renovation program, so we're selling properties and we're also buying new properties. This quarter to-date, the December quarter has been particularly active for that. We've already closed 2 significant deals and we've got others we're planning and we continue to find interesting pockets. There is lot of capital out there sort of everywhere in all asset classes. But on a relative basis, interestingly, our view is real estate has less than corporate credit right now, which I think is something to do with how institutional investors have allocated in the last year to anything touching our floating rate. So we like the real estate business. It's not technically a credit business, it's an equity business, but it's a heavy cash yield business and the most credit like with diversified counterparty exposure, multifamily. It's a great inflation hedge. That's a great beneficiary of attractive financing and we lock in for 10 years. We don't gamble on interest rates. So we have really a long-time horizon of locked in financing. We've got the ability to do dividend recaps when properties significantly outperform, as we've done in significant parts of the real estate portfolio to monetize the position and then redeploy. So we're very, very pleased with that business. It's a low hit rate business in terms of a book-to-book ratio, but that's part and parcel of our business. Elsewhere on the control side, you'll see us continue to selectively look at other control investments. We've been doing add-on acquisition opportunities for MityLite for example, which is a furniture maker that addresses the hospitality and restaurant and many other -- the institutional and hospital segment as well and we've been finding attractive places to deploy capital there. And you'll see it selectively look at other deals where we have a competitive advantage of being able to supply one-stop capital. You are not going to see us chase deals at high valuations or [quite] value driven. And then there is our financial buyouts also in the control book which is largely in consumer credit, 2 installment lenders and 1 auto finance business, and you had seen an increase in charge-offs earlier in calendar year 2017. We're pleased to see improvement there. We think many of these businesses have turned the corner and are starting to bottom out and show growth again. And we're also seeing a much more favorable regulatory environment right now for those types of businesses than with the case a year or 2 ago. So it's all bottoms up deal by deal and looking for attractive place to deploy capital, but the control book is certainly 1 area, and another important aspect to mention is, when you own a business or position, if you decide to sell it, it's your decision, one of the very tough things about the credit side -- the corporate credit side in the middle market is when a credit does particularly well, you either have to put up more money to recap and or you get pay it off. Spreads are fleeting and repayments really can spike, we have been having so far this quarter, but we've had periods of significant repayments and we expect that will be the case as well from time to time in the future. So you can hang to a steady, recurring cash flow business and not have to constantly be redeploying like you do in the credit side of things. So there's a lot of advantages to the control book.

The next question is from Christopher Testa of National Securities Corporation.

Just looking at the challenging middle market environment where you guys are trading in the dividend yield, just wondering why you're not massively repurchasing stock?

Chris, thank you for your question. We have repurchased stock in the past, we have about a $100 million authorization from the board for repurchases. I think we've used about 1/3 of that to-date. We had slowed buybacks previously because we're worried about the volatility impact on leverage, circumstances can change pretty swiftly; 2 years ago, year and a half, end of 2015, early 2016, our folks thought we're about to hit another recession and you had a huge uptick in volatility. The rating agencies have made it crystal clear to us and I think others in the industry that buybacks are a big negative from a rating standpoint which makes us cautious and we need to be careful in managing other compliance baskets that are critical to manage from a legal and tax standpoint, including our 30% basket, if we get a big surge in repayments coming out of the 70% basket and you end up off size on the 30% basket, which is an incurrence, not a maintenance test, it means you actually [can't] put in a single penny into a 30% basket investment even something that might have a 200% IRR attached to it, like some of the resets and areas in our structured credit business or attractive synergistic add-ons that we are exploring, for example, our financial services portfolio. So to be careful about that -- to be careful about our RIC diversity tests as well and other aspects where scale is important. We have earned on the real estate side, as I mentioned, 30% IRRs approximately within NPRC and we are just inactively redeploying capital there. So those are some of the factors, Chris, which is I would say, makes it an ongoing discussion item for the business.

I can understand those points but I mean, what type of discount and riskless return on capital from accretive buybacks would the board need to induce them to actually implement the program and you guys actively do it?

Yes, Chris, it doesn't come down to 1 number. The cost of not complying, the cost of having liability access issues, those can be incalculable as well. So it's a multifactor analysis, Chris, it doesn't come down to 1 simple formulatic number.

And just touching on the online consumer lending business. Just wondering if your outlook on that business has changed, given the kind of capital results coming out of Lending Club and OnDeck.

With OnDeck, that has always been a very small part of our business. I mean, how big is that book right now, Brian, $15 million maybe?

Yes, it's right.

It's a tiny part of our business.

I understand, I just mean but it's in the same line of business as what you're doing in the online lending, so...

The small business lending has always been a very small business in part because originators like the one you mentioned had become balance sheet lenders themselves as opposed to sellers of assets to folks like us in part because they're such short-term assets, 3 to 6 months. There's been good performance, but capital comes back to you so swiftly, you don't see very -- you don't see large portfolios out there really of any scale, kind of like venture lending, for example. It's very hard to scale that business because money comes back to you so fast. And then on the consumer side, which is the bulk of what we do within NPRC and the team there, you talked about [tepid] results, Lending Club. We're very happy with our Lending Club platform results. The remarks that they made this week pertain to other types of assets that are not the assets we hold, were in their policy too which is not publicly reported and really more near-prime centric as opposed to lower-price centric. So we're happy with the performance, debt investors are happy with the performance, securitization arrangers are happy with the performance, which is why you saw a securitization in June and why in our prepared remarks I talked about gearing up for the next securitization as well and some of the other platforms that we've done sort of legacy ones years ago, we have not been actively deploying new capital or growing those books in any significant fashion for quite a while and we're actually looking at doing effectively a dividend recap to take capital out of that business and then redeploy, might deployed into Lending Club near prime originations, might deploy it somewhere else within NPRC or take it back to PSEC and deploy it somewhere else entirely. So that's all part of the ongoing optimization for the online business. Is that helpful, Chris?

I'm sorry, I had that muted, yes. Just on the CLO equity valuation, how many instances are there when the third party that you use has a valuation that's higher than the nonbinding indicative bids that you receive in the portfolio?

I'm trying to understand the question. The valuation, which is 100% third party, speaks as of a certain date. These are highly [illiquid] level 3 assets. You don't really have daily trades in the marketplace. So..

Right, but if you have, let's say -- if you could receive a nonbinding indicative bid on, let's say, a good portion on the portfolio. Obviously, the third-party valuation firm is coming up with their own valuation. But nonetheless, how many -- I'm just asking, how many times is the valuation -- that Gifford gives you, how many times is that higher than with the nonbinding indicative bid is on the book?

I'm not sure, Chris. I'll say nonbinding indicative bids are worth the paper they're written on. Actual closed transactions are lot more meaningful and you don't have very many data points to look at and what is a highly illiquid part of the marketplace. One piece I want to address on the valuation front, I know you've said commentary on this as well, is when you look at our CLO book and you -- and some people compare them to other practitioners that the industry that run RICs and report valuations. And you look at, on an aggregate basis, valuation as a percent of cost, what you see actually is that PSEC's CLO structured credit book is in line with or below comps and be will by a pretty significant degree, what you'll also see -- and again this is 100% third party, we don't do valuations run here as a management team. We don't do the valuations, they're done by a third party. What you also see is a significantly below income recognition which our management team is much more involved and approved by auditors to the tune of 500 basis points below others in the marketplace. So we're very secure and confident in our conservative accounting surrounding our structure credit business.

There are no additional questions at this time. This concludes our question-and-answer session. I would like to turn the conference over to John Barry for closing remarks.

Thank you, everyone. Have a wonderful afternoon and thank you for joining the call. Bye now.

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