Prospect Capital Corp (PSEC) 2019 Q2 法說會逐字稿

Good morning, and welcome to the Prospect Capital Corporation second fiscal quarter earnings release and conference call. (Operator Instructions) Please note this event is being recorded.

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

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

Thanks, John. This call is the property of Prospect Capital Corporation. Unauthorized use is prohibited. This call contains forward-looking statements within the meaning of the securities laws that are intended to be subject to safe harbor protection. Actual outcomes and results could differ materially from those 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 on our website, prospectstreet.com.

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

Thanks, Kristin. For the December 2018 quarter, our net investment income or NII was $80.8 million, $0.22 per share, down $0.01 from the prior quarter and exceeding our current dividend rate of $0.18 by $0.04.

NII decreased due to higher operating expenses, partially offset by higher structuring fee income. In the December 2018 quarter, our net debt-to-equity ratio was 75%, down 0.1% from the prior quarter. Taking into account changes in balance sheet values as of the market close on December 31, 2018, our net loss for the quarter was $67.4 million or $0.18 per share, a decrease of $0.41 from the prior quarter. This change was driven primarily by unrealized losses in the portfolio, including a decline in industry valuations in the debt and equity capital markets as of the market close, December 31, 2018.

We are announcing monthly cash distributions to shareholders of $0.06 per share for each of February, March and April, representing 129 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in May. Since our IPO nearly 15 years ago, through our April 2019 distribution at our current share count, we will have paid out $17.16 per share to original shareholders, aggregating approximately $2.8 billion in cumulative distributions to all shareholders. Our NAV stood at $9.02 per share in December 2018, down $0.37 from the prior quarter. Thank you.

I'll now turn the call over to Grier.

Thank you, 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 nonsponsor lending; Prospect sponsored operating and financial buyouts; structured credit; real estate yield investing and online lending.

As of December 2018, our controlled investments at fair values stood at 41.6% of our portfolio, down 0.3% from the prior quarter. 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 December 2018, our portfolio at fair value comprised 46.2% secured first lien, which was up 1.8% from the prior quarter; 23.1% secured second lien, which was up 1.4% from the prior quarter; 16% structured credit with underlying secured first lien collateral, down 0.3% from the prior quarter; 0.4% unsecured debt, down 0.1%; and 14.3% equity, down 2.8% from the prior quarter, resulting in 85% of our investments being assets with underlying secured debt benefiting from borrower-pledged collateral.

Our approach is one that generates attractive risk-adjusted yields. And our debt investments were generating an annualized yield of 13.1% as of December 2018, down 0.4% from the prior quarter. We also hold equity positions and certain investments that can act as yield enhancers or capital gains contributors as such positions generate distributions. We've continued to prioritize senior and secured debt with our originations to protect against downside risk while still achieving above market yields through credit selection discipline and a differentiated origination approach.

As of December 2018, we held 139 portfolio companies, up 2 from the prior quarter with a fair value of $5.84 billion. We also continued to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration, the largest is 13.8%. As of December 2018, our asset concentration in the energy industry stood at 3%. And our concentration in the retail industry stood at 0%.

Nonaccruals as a percentage of total assets stood at approximately 3.6% in December, up 1.2% from the prior quarter. Our weighted average portfolio net leverage stood at 4.57x EBITDA, down from the prior quarter and the third straight quarterly decrease.

Our weighted average EBITDA per portfolio company stood at $58.5 million in December, up from $56.5 million the prior quarter.

The largest segment of our portfolio consists of sole-agented and self-originated middle market loans. In recent years, we perceived the risk-adjusted reward to be higher for agented, self-originated and anchor investor opportunities compared to the nonanchor 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 December aggregated $226 million. We also experienced $164 million of repayments and exits as a validation of our capital preservation objective, resulting in net originations of $63 million.

During the December quarter, our originations comprised 64% nonagented debt, including early look anchoring and club investments; 19% structured credit; 15% agented sponsor debt; 2% agented nonsponsor debt; and 1% real estate.

Today, we've made multiple investments in the real estate arena through our private REIT strategy, largely focused on multifamily stabilized yield acquisitions with attractive 10 or more year financing.

NPRC or private REIT has the real estate portfolio that's benefited from rising rents, strong occupancies, high-returning value-added renovation program and 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 12 properties, including 3 since our last earnings release consisting of City West, Island Club and Vinings, with an objective to redeploy capital into new property acquisitions, including with repeat property manager relationships. We expect our exits to continue and have identified multiple additional properties for potential exit in calendar year 2019.

Our structured credit business has delivered attractive cash yields, demonstrating the benefits of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities. As of December, we held $937 million across 48 nonrecourse structured credit investments, primarily in the subordinated tranche. The underlying structured credit portfolios comprised over 1,800 loans and a total asset base of over $19 billion.

As of December, our structured credit portfolio experienced a trailing 12-month default rate of 92 basis points, down 21 basis points from the prior quarter and 71 basis points less than the broadly syndicated market default rate of 163 basis points.

In the December quarter, this portfolio generated an annualized cash yield of 21%, and an annualized GAAP yield of 15.5%, up 1.1% from the prior quarter.

Cash yield includes all cash distributions from an investment, while GAAP yield subtracts out amortization of cost basis. As of December, our existing structured credit portfolio has generated over $1.24 billion in cumulative cash distributions to us, representing around 81% of our original investment. Through December, we've also exited 11 investments, totaling just under $300 million with an average realized IRR of 16.1% and cash and cash multiple of 1.5x.

Our structured credit book consists entirely of majority-owned positions. Such positions can enjoy significant benefits comprise -- 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 and extend or reset the investment period to enhance value.

We've completed 22 refis and resets in the past year. Our structured credit equity portfolio has paid us an average 17.5% cash yield in the 12 months ended December 2018. So far in the current March quarter, we booked $3 million in originations and received repayments of $44 million, resulting in net repayments of $41 million. Originations have consisted of nonagented debt. Thank you.

I'll now turn the call over to Kristin.

Thank you, Grier. 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 strengths as well as substantial liquidity to capitalize on attractive opportunities. Our company has locked in a ladder of fixed-rate liabilities extending 24 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 and many other lists of first. 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 December 2018, we held approximately $4.3 billion of our assets as unencumbered assets, representing approximately 72% of our portfolio. The remaining assets are pledged to Prospect Capital funding, where we recently completed an extension of our revolver by 5.7 years, reducing the interest rate on drawn amounts to 1-month LIBOR plus 220 basis points.

We currently have $1.02 billion of commitments from 29 banks, with $1.5 billion total size accordion feature at our option. We are targeting adding more commitments from additional lenders. The facility revolves until March 2022, followed by 2 years 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, including recently 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 rating of BBB from Kroll; an investment grade rating of BBB from Egan-Jones; an investment grade BBB- rating from S&P. And we recently received investment-grade Baa3 rating from Moody's. So a total of 4 investment grade ratings.

We've now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 24 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we have substantially reduced our counterparty risk over the years.

In the December 2018 quarter, we repurchased $13.5 million of our April 2020 notes as well as $70 million of our program notes. We have also issued $50 million of 2029 baby bond notes; $7 million of baby bonds through our ATM program; and continued weekly Internet issuances. If the need should arise to decrease our leverage ratio, we believe we could flow origination and allow repayments and exits to come in during the ordinary course. As we have demonstrated in the first half of calendar year 2016, during market volatility. We now have 8 separate unsecured debt issuances aggregating $1.6 billion, not including our program notes with maturities extending to June 2029.

As of December 2018, we had $726 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, Kristin. We can now answer any questions.

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

So my first question for today, on the NAV markdown, how much of that is just from the temporary market movements that, that were really moving late December for our space versus company-specific issues?

See Leslie, this is John speaking. I was looking to do that calculation this morning. But I don't have all of the numbers. I don't know if Kristin or Grier have performed that calculation. As you pointed out...

Right. We anticipated that question, of course, we've been asking ourselves. It's tough to unpack fully, Leslie, but just as a rough -- very rough estimate, say about half from sort of macro flash crash if you will, forces impacted December. Some of which potentially has come back. Although maybe volatility is back today. It's obviously, a day-by-day assessment of the overall capital markets. But as a very rough estimate, maybe 50-50.

And Leslie, I think if you look at the LSTA or some small-cap middle-market credit indices, my estimate is a recovery of about 50% from December 31.

Okay, perfect. And then you went through in the prepared remarks, the originations, no repayments so far in the quarter. But I'm afraid I missed those numbers writing them down. Could you repeat those, please?

Go ahead, Grier.

Sure, Leslie. And it's in the -- please, it's in our earnings release as well. But we had about $3 million gross, $44 million repayment. And then so net repayments of $41 million. It's obviously been a very quiet market year-to-date because of how volatility sees the market. And I think that's pretty much across the board of the industry, not just ourselves.

And then in the December quarter, you had $226 million gross originations. Were those pretty early on in the quarter? Or was that all overweighted towards the end? How did those come in?

I mean, these things are not on a perfect conveyer belt, right? Sometimes you'll commit to a deal and it will settle if it's a club or quasi-syndicated deal several weeks later. I don't have the exact schedule. My general sense is that it's a little bit more weighted towards the first half of the quarter. I mean, between Thanksgiving and the holidays is usually a slower time, anyway, from a seasonality perspective. And when volatility gripped the market this particular year, a lot of processes just got kicked into 2019. So for first half of the quarter was a little bit more active than the latter part. But we continue to be active in all fronts of our business. Real estate, for example, we sold a property in December. We sold another property in January. So it's nice to have a more diversified business model than many others in our industry because parts of the business are zigging while others are zagging. So the real estate market has continued to be a lot more active and a lot more robust, we've noticed than the corporate credit side of things.

Okay. And congratulations on the Moody's investment grade rating. Now that you also have that one as well, is there any reconsideration on changing the asset coverage requirement for Prospect? And if so would there be a time line that may take a little bit longer because of the outstanding InterNotes in those covenants?

No changes anticipated. We continue to be quite comfortable with -- staying within 200% asset coverage. And as well we question at this part of the cycle, strategies that others are espousing to lever up. We think exactly -- it's exactly the time in the cycle when you should be doing the opposite. And that's what we're doing.

Okay. And then just on some portfolio investments. Just an update on 2 of the nonaccruals InterDent, which is one of your larger investments on the portfolio had 2 nonaccruing loans under that name? And then Pacific World?

Correct.

Yes, can I just -- is there an update on those assets?

Sure. So -- and these have become controlled investments in the past year, that's not new information. In the case of InterDent, the dental services company primarily West Coast-focused. We're looking at various growth and profitability boosting initiatives. And have been reinvesting back in the business, particularly, for branch digitization, dental and hygienist recruitment and retention initiatives, which is very important, given the current labor market dynamic. Just a lot of blocking and tackling. Some exciting growth initiatives potentially there. But we have turned off the accrual in some of the more junior tranches. In the case of Pacific World, which is a deeper and more -- and trickier turnaround. We recently recruited to the company a world-class CEO, who used to be the CEO of one of our prior portfolio companies and did a terrific job with that business turning it around. So we expect that will be, again perhaps, a longer time horizon to do the turnaround. When we took over the business, we found a lot of issues that needed to be addressed. So I think we've said in the past that things will get worse before they get better. And that's I think the case with that company. But with the right people in charge, we're cautiously optimistic about the future. John, anything you want to add about that?

Sure. So Leslie, thank you. Though you put your finger pointing very quickly on I think what to me are the 2 biggest takeaways from the December quarter. One is the impact of the volatility in late December. All our remarks are, as you know, the close of business, December 31. And the markets recovered to varying degrees since then, yet volatility continues. So you put your finger on that. And the second area of attention for me is these 2 companies, PWC and InterDent. Both are substantial companies with significant revenue. I mean, what's happened is that the margins and profitability under prior management were squeezed. And in the case of at least one of the managers, I would say, a compromised manager. So unfortunately, sometimes when we make a loan to a sponsor buying a company, we discovered it. We have to take over and manage the company ourselves. The good news is that had we not taken over these 2 companies, I think we would be in more distress than now. Because in each case, the sponsor, in my personal opinion, was not doing the most basic things that are required to maintain forward momentum for a company in a competitive capitalist economy. Grier is correct. Our #1 initiative when these problems occur with respect to loans, and we become an owner of a company is to find a CEO that we have confidence in and that we can back completely. And fortunately, in the case of each company, InterDent and PWC, we have been able to find that person. M'lou Walker, for example, ran Zicam. I think, Leslie, since you seem quite familiar with our portfolio, you may have noticed that Zicam performed very well for H.I.G. and for us. And we were fortunate to be able to recruit M'lou Walker to run PWC. It's a long process to reverse decline, to reverse margin compression, to deal with tariffs on Chinese goods where the company did a great and does -- still does a great deal of sourcing. So it's interesting. In my experience in life, if I'm driving my car and the spark plug doesn't work, the next thing, it's the carburetor, then it's the oil pressure. It seems that everything goes wrong at the same time. And that's what happened at PWC. Sometimes I think an ill wind blows no good. And the prior management. Thank goodness, we were able to take over the company quickly and install new management fairly quickly. Neither of which can ever be assumed. So at least now we stemmed the decline. We still have significant revenue. We have protected very important customer relationships with Walmart, Wal -- I think it’s Walgreens, CVS where the company has significant sales. What we need to do is come back up the curve in terms of the company's brands, with -- people discuss whether we should be doing more rather than less private label. In my personal view is more brands, less private label. Again, that from M'lou Walker and her team to decide. M'lou has recruited a new CFO. She's recruited a new head of Marketing. She has recruited a new manager for the supply chain. Imagine how much work that is. I don't know if you've ever had to recruit an entirely new management team. We're grateful for her attention to this business. And we can see that the way she's handling PWC is the reason why Zicam was so successful. In the case of InterDent, the company lost a major contract under the prior management. We -- personally, Grier and I were mystified and still are mystified, how that can happen with no prior warning. And with the prior management telling us that, that's business as usual. We don't see that as business as usual at all, losing a major contract. Fortunately, the new management that's in there. Grier, do you recall the name of the new CEO? I confess that I do not right now.

There's a co-CEO situation at the moment.

At InterDent.

Yes.

All right. One of the 2 people has been at the company. And is a -- how would I put it. A can do -- "let me get in on a playing field coach. I know I'm going to be scoring some goals here". And we're hoping for the turnaround there. It's a different chat. At PWC, the challenge is to protect the company's brands, to make more efficient the supply chain, to protect the relationship with Walmart and others. All of which is happening. How quickly that will generate the EBITDA that we saw in the past, I can't tell you. Hopefully, we're not waiting years for that. At InterDent, the challenge is to get these major contracts with these public agencies. And how -- they're given out every year. I think it's an annual process. We believe the team that's there now is much more attentive to the political realities of getting major government contracts, which starts with knowing your customer and knowing what your customers wants, and knowing what your customer is thinking. And why those bromides fell by the wayside at InterDent is mystifying to us. But in each case, as Grier said, things get -- when you take over a company, you -- as a lender, it's not what you want to be doing. You only do that as an absolute last resort when it's observable that the prior owner is not caring for the company. Usually because the prior owner has no measurable economic interest other than a speculative interest. So fortunately, we've been able to get control of these companies. We own the majority of the upside. And with -- if you believe that in business careful, painstaking, diligent, detailed work as Grier mentioned, blocking and tackling. If you think that, that is the road to business success, then you will be happy to see that we have people at both of those companies that are pursuing that line of thinking. And the question then is, how long will it take to see results. I wish they were yesterday. We'll see. By the time of the next earnings call, I hope we'll have more tangible good news to report with respect to the financial operations and not just the hiring of new management. Does that help, Leslie?

That does. Appreciate the detail. I guess, my last question then is on the structured products and CLOs. Just kind of in general, not necessarily any one specific. But it seems like the ones through Halcyon, and I'm sure I'm mispronouncing these, EPIDOS, Voya and Galaxy. Almost all of those are at 0 effective yields right now. Is there a reason it's had to deal with market volatility last quarter? Is that structure or structural-related with those healthy names, Halcyon, EPIDOS, et cetera. And so what's driving that?

Want me to take that, John?

Oh, sure.

Okay. So in our structured credit book, we have 48 positions. And so it's a highly diversified book. There's a tendency sometimes to generalize about this type of business. But the reality is, some deals that significantly outperform and a few others that are on the opposite end of the spectrum, that's what they need to diversify portfolio. So we benefit from that diversity. In the cases of some of the deals you mentioned, those collateral managers ran with higher energy mixes during the 2014 to 2017 downturn in that sector. And collateral managers -- everybody is impacted by energy in some fashion, within the probably syndicated CLO market. And most notably of that was sort of 0 exposure. But some folks and this is kind of interesting behavior to observe and looking at the last cycle as well. Some folks decided to sell at the bottom, crystallize losses, and then redeploy. Others certainly much better to hold on to see value restored in some fashion. And then basically not crystallize the loss. The vast book of our managers did the latter, some did the former. We disagreed with it, and you see some of the results as well from selling at the bottom. And those are tricky transactions we're trying to -- basically, what we do with every deal, Leslie, is we go through a series of different options and run an NPV analysis. So we're going to look at does it make sense to -- well, there's always the status quo sort of do-nothing option, but does it make sense to reset these transactions and then you look at different years of such recess. In some cases, we'll need to put in additional capital based on the way the over collateralization tests work. In other cases, we're going to get capital back. So an infinite return type IRR proposition. But of course, you can still calculate an NPV if that cases well to equalize across all. In other cases, a straight refinancing, without a movement back in the deal time horizon. And then there's also calling a deal, which is an option available to us as the majority holder that's not typically the case with folks that hold much smaller positions. So analyze all those, and we're making optimal decisions in a vast bulk of cases across the book in 2018, the NPV signals said that we should reset a large swaps of deals. And that's why we were successful, and we're aggressive in getting ahead of the queue and muscling for and using our influence to get done. About half of the book approximately, we got reset in 2018. Other deals, the ones you mentioned are trickier, mainly because of that energy phenomenon that I mentioned and where the collateral is. So we're managing through those. The way the GAAP yield calculation works is it does a projected cash flow is essentially in IRR calculation. And so if there's not -- if there's not sufficient cash flows embedded in the expectations of a particular deal, there won't be GAAP yield. So you see that for a small number of deals. But in other cases, obviously, we've got much, much greater yield. So we're going to be very patient. We're going to make the wise decision and sometimes when we wound deals up, 90% of the collateral gets sold. But there's another sort of 10% stub that doesn't get sold. Usually, it's defaulted equity -- equitized positions, or areas where we and our -- the management team views there's additional upside. So rather than liquidate in a hasty, in a prudent manner to patiently hold on for more value. That patience has been rewarded in deals, including in the past quarter. So we're going through that now, but I think what you see is a positive reflection of some improper and conservative accounting about these things. No, we don't recognize every last penny of cash yield as GAAP income. That's not proper. We instead use the levelized yield method, which is essentially an IRR calculation. So hopefully that was helpful to you, Leslie?

It was.

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

Okay. Thank you, everyone. We appreciate your interest. Have a wonderful afternoon. Bye now.

Thank you.

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