Earnings Call Transcript - PSEC Q2 2021

Operator, Operator

Good day, and welcome to the Second Fiscal Quarter Earnings Release and Conference Call for Prospect Capital Corporation. 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.

John Barry, Chairman and CEO

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

Kristin Van Dask, CFO

Thank you, 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 forecasts due to the impact of many factors. We do not undertake to update our forward-looking statements unless required by law. For additional disclosure, see our earnings press release and our 10-Q filed previously and available on the Investor Relations tab on our website, prospectstreet.com. Now I'll turn the call back over to John.

John Barry, Chairman and CEO

Thank you, Kristin. In the December quarter, our net investment income, or NII, was $81.6 million or $0.21 per common share, up $0.06 from the prior quarter. Our net income was $306 million or $0.80 per common share, up $0.35 from the prior quarter. Our NAV stood at $8.96 per common share in December, up $0.56 and 7% from the prior quarter and representing our third quarter in a row with NAV growth. In the December quarter, our net debt-to-equity ratio was 61.1%, down 13% from March and down 7% from September. In May, we moved our minimum 1940 Act Regulatory asset coverage to 150%, equivalent to 200% debt-to-equity. We have no plans to increase our actual drawn debt leverage beyond our historical target of 0.7 to 0.85 debt-to-equity. And we are significantly below such target range now. We are announcing monthly cash common shareholder distributions of $0.06 per share for each of February, March, and April. These three months represent the 42nd, 43rd, and 44th consecutive $0.06 dividends. Consistent with past practice, we plan on our next set of shareholder distribution announcements in May. Since our IPO nearly 17 years ago, through our April 2021 distribution at the current share count, we will have paid out $8.60 per common share to original shareholders, aggregating over $3.3 billion in cumulative distributions to all common shareholders. Since October 2017, our NII per common share has aggregated $2.55 while our shareholder distributions per share have aggregated $2.34, resulting in our NII exceeding distributions during this period by $0.21 per share. Our NII covered distributions in the June 2020 fiscal year and have covered distributions in the 2021 fiscal year-to-date as well. We are also pleased to announce continued preferred shareholder distributions on the yields of successful launches over $1 billion, 5.5% preferred stock program. And $250 million, 5.5%, preferred stock program. Thank you. I'll now turn the call over to Grier.

Grier Eliasek, President and COO

Thank you, John. Our scale platform with over $6.1 billion of assets and on John Credit continues to deliver solid performance in the current challenging environment. Our experienced team consists of around 100 professionals, which represents one of the largest middle-market investment groups in the industry. With our scale, longevity, experience, and deep bench, we continue to focus on a diversified investment strategy that spans third-party, private equity sponsor-related lending, direct non-sponsor lending, prospect-sponsored operating, and financial buyouts, structured credit, and real estate yield investing. Consistent with past cycles, we expect during the next downturn to see an increase in secondary opportunities, coupled with wider spread primary opportunities with a pullback from other investment groups, particularly more highly leveraged ones. 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, our portfolio at fair value comprised over 47% secured first lien, 21% other senior secured debt, 13% subordinated structured notes with underlying secured first lien collateral, and 18% equity investments, which results in a stable 82% 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 are performing interest-bearing investments, we're generating an annualized yield of 12.2% as of December, which was up 0.6% from the prior quarter. We achieved this increase despite a headwind from the past year's decline in LIBOR though we expect stability now due to our LIBOR floors. We also hold equity positions in certain investments; they can act 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, we held 122 direct portfolio companies even with the prior quarter with a fair value of over $5.6 billion, which is an increase of $239 million from the prior quarter. We also continued to divest in a diversified fashion across many different portfolio company industries, with no significant industry concentration. The largest is 16%. As of December, our asset concentration in the energy industry was 1.2%, in the hotel, restaurant, and leisure sector 0.4%, and in the retail industry, 0%. Non-accruals as a percentage of total assets stood at approximately 0.7% in December, flat from the prior quarter. Our weighted average middle market portfolio net leverage stood at 4.97x EBITDA, down 0.31 from the prior quarter and substantially below our reporting peers. Our weighted average EBITDA per portfolio company stood at $83 million in December, which was an increase from $78.5 million in the prior quarter. Originations in the December quarter aggregated at $346 million. We also experienced $338 million of repayments and exits as a validation of our capital preservation objective and sell-down of larger credit exposures, which resulted in net originations of $8 million. During the December quarter, our originations comprised 25% middle market finance, 24.8% real estate, and 0.2% middle market lending buyouts. To date, we've deployed significant capital in the real estate arena through our private REIT strategy, largely focused on multifamily workforce, stabilized yield acquisition with attractive 10-year-plus financing. NPRC, our private REIT, has real estate properties that have benefited over the last several years 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 as of December has exited completely 33 properties at an average IRR of 23.5% with an objective to redeploy capital into new property acquisitions including with repeat property manager relationships. We continue to monitor our rent collections, which are holding up well in the current environment. 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 $745 million across 39 nonrecourse subordinated structured notes investments. These underlying structured credit portfolios comprised around 1,700 loans and a total asset base of around $17 billion. As of December, the structured credit portfolio experienced a trailing 12-month default rate of 206 basis points down 14 from the prior quarter and representing 177 basis points less than the broadly syndicated market default rate of 383 basis points. In December, this portfolio generated an annualized cash yield of 17.2% and a GAAP yield of 16.8%. As of December, our subordinated structured credit portfolio has generated $1.26 billion in cumulative cash distributions to us, representing around 90% of our original investment. Through December, we've also exited non-investments totaling $263 million with an average realized IRR of 16.7% and a cash-on-cash multiple of 1.48x. Our subordinated 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. With 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. We've completed 27 refinancings and resets since December 2017. So far in the current March quarter, we have booked $12 million in originations and experienced $53 million of repayments for $41 million of net repayments. Originations have comprised 56.5% real estate, 41.4% middle market finance, and 2% middle market lending buyouts. Thank you. I'll now turn the call over to Kristin.

Kristin Van Dask, CFO

Thank you, Grier. We believe our prudent leverage, diversified access to matchbook funding, substantial majority of unencumbered assets, waiting towards unsecured extended asset commitments and lack of near-term maturities demonstrate both balance sheet strengths as well as substantial liquidity to capitalize on attractive opportunities. Our company has locked in a ladder of liabilities extending 22 years into the future. Today, we have zero-debt maturing until July 2022. Our total unfunded eligible commitments to noncontrolled portfolio companies totaled approximately $21 million or less than 0.4% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stand at approximately $845 million. We are a leader and an innovator in the marketplace. We were the first company in our industry to issue a convertible bond, develop a notes program, issue under a bond ATM, acquire another BDC and many other lists of Firsts. Now we've added our programmatic perpetual preferred issuance to that list of Firsts. Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry, which we have taken toward the construction of the right-hand side of our balance sheet. As of December 2020, we held approximately $4.21 billion of our assets as unencumbered assets, representing approximately 74% of our portfolio. The remaining assets are pledged to Prospect Capital funding, where in September 2019, we completed an extension of our revolver to a refreshed 5-year maturity. We currently have $1.0775 billion from 30 banks. The facility revolves until September 2023, followed by a year of amortization with interest distributions continuing to be allowed to us. Of our floating rate assets, 89.6% have LIBOR floors with a weighted average floor of 1.63%. Outside of our revolver and benefiting from our unencumbered assets, we've issued that Prospect Capital Corporation including in the past few years multiple types of investment-grade unsecured debt, including convertible bonds, institutional bonds, baby bonds, and program notes. All of these types of unsecured debt have no financial covenants, no asset restrictions, and no cross defaults with our revolver. We enjoy an investment-grade BBB- rating from S&P, an investment grade BAA3 rating from Moody's, an investment-grade BBB- rating from Kroll, and an investment-grade BBB rating from Egan-Jones. We've now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 22 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 2020 quarter, we completed successful tender offerings, retiring around $66 million of our 2022 notes, $30 million of our 2023 notes, and $10 million of our 6.375% 2024 notes. In the current March quarter through tender processes, we have retired $20 million in 2025 notes and another $27 million of 2022 notes, thereby taking that tranche down to $136 million. We recently, in the current March quarter, issued $325 million in unsecured debt maturing in January 2026 with a coupon of 3.7%. We have continued to substitute more expensive term debt with significantly lower cost revolving credit with an incremental 1.3% cost and our newly issued 2026 notes. We also have continued with our weekly programmatic internotes issuance on an efficient funding basis. We now have 8 separate unsecured debt issuances aggregating $1.4 billion, not including our program notes, with maturities extending to June 2029. As of December 2020, we had $759 million of program notes outstanding with staggered maturities through October 2043. We also recently added a shareholder loyalty benefit to our dividend reinvestment plan, or DRIP, that allows for a 5% discount to the market price for DRIP participants. As many brokerage firms either do not make DRIPs automatic or have their own synthetic DRIPs with no such 5% discount benefit, we encourage any shareholder interested in DRIP participation to contact your broker. Make sure to specify you wish to participate in the Prospect Capital Corporation DRIP plan through DTC at a 5% discount and obtain confirmation of that from your broker.

John Barry, Chairman and CEO

Thank you, Kristin. We could take questions now.

Operator, Operator

The first question is from Finian O'Shea with Wells Fargo Securities.

Finian O'Shea, Analyst

I guess the first question, Grier, on the CLO portfolio this quarter. You saw a pretty good rebound there in yields. I know cash yields were up this quarter for that asset class. But any expanded color on longer-term improvement there?

Grier Eliasek, President and COO

Certainly. This part of our portfolio represents about 13% of our assets and has performed as expected. These are self-healing vehicles, and during times of stress like in 2020, we experienced some ratings downgrades impacting the syndicated loan market. We dealt with temporary disruptions in cash flows on a few deals, but that situation has largely improved. Cash yields have risen to 17.2%, up about 1,100 basis points from the previous quarter, while GAAP yields have increased by approximately 320 basis points to just under 17%. Looking at the long term, we're not only seeing loan prices rise, but we're also witnessing a reversal of some ratings downgrades into upgrades, which usually happens more slowly and tends to be asymmetric. However, this is a positive trend. The trailing 12-month default rates have also reached a low point. Historically, we've outperformed the overall loan market by around 50%, and this trend is continuing with a decline in default rates expected as we move forward, reflecting a runoff of past defaults. We're feeling optimistic about the loan sector. Additionally, we are benefiting from LIBOR floors, which can sometimes be advantageous or disadvantageous. In this case, since our floors are above the current rates, they are beneficial as LIBOR is close to zero. We are receiving good payments on the asset side due to the floor plus the spread, while our liabilities don’t have such a floor. Many positive developments are happening here, though this portion of our portfolio is small and unlikely to expand on our balance sheet. Any follow-up questions, Finian?

Finian O'Shea, Analyst

That was helpful. I have two follow-up questions about the right side of the balance sheet for perhaps Kristin. I think you mentioned that you would be using the revolver more, and we've noticed that. How much would you ideally say you would like to utilize? Additionally, if you have the figures, can you remind us of your available borrowing base?

Grier Eliasek, President and COO

I'll address the first part, and then Kristin can discuss the borrowing base, which is a topic that evolves as we fund more originations and pledge more assets. This causes the borrowing base to grow gradually instead of remaining constant. Historically, our revolver has been utilized at about 15%, but we've increased that to around 35%. We aim to maintain a proper balance with sufficient liquidity available, which we believe is crucial for reducing risk while making use of our most efficient financing options. We've been eliminating more expensive debt through various tenders. Recently, we are calling back a costly traded baby bond, which will be retired this week, following a notice given nearly 30 days ago along with our new institutional bond issuance. We are replacing debt in the 5% to 6.5% range with debt in the 3% to 4% range on a term basis, along with a revolver costing just over 1%. These steps have allowed us to reduce our financing costs on the right side of our balance sheet, and we plan to continue refining that approach to drive further gains. Currently, we are significantly under-levered, with a net debt-to-equity ratio of 61%, against a target range of 70% to 85%. While we remain cautious, we have a solid pipeline of deals ready to utilize that capital. Both financing costs and the amount of financing available are key levers for enhancing future earnings. We also have about $845 million in combined cash and undrawn revolver. Kristin, would you like to add any insights on the borrowing base, which, again, grows as we pledge more assets?

Kristin Van Dask, CFO

Sure, Grier, you just mentioned the $845 million that we have on the cash and undrawn. We currently have about $370 million borrowed with an additional $430 million available to us on our current borrowing base.

Operator, Operator

The next question comes from Robert Dodd of Raymond James.

Robert Dodd, Analyst

Congratulations on a strong NAV quarter and for being one of the top 100 stocks on Robinhood. The NAV performance was impressive, rising 7%. A significant portion of this came from two assets, specifically InterDent and your REIT. I have a few questions regarding this. For InterDent, there's been a noteworthy increase, marking the first time this asset has exceeded its cost in quite some time. This business has faced challenges for over a decade, even before your involvement. Has there been another restructuring? What changes have occurred that put it on a better trajectory? It's clear that the dental sector has rebounded to some extent, although there are still challenges. What led to the substantial increase in this business this quarter?

Grier Eliasek, President and COO

I don't completely agree with that perspective. InterDent has faced long-term challenges. The company operates in two segments: a Medicaid-based business primarily in Oregon, and a fee-for-service business in other states, mostly in the western region. The Medicaid business turned out to be advantageous during the past year because even when utilization decreased, the costs dropped while the payments remained stable. This segment has shown strong performance compared to the fee-for-service model, which is not as common in the industry. While there are risks associated with reimbursement and Medicaid enrollment fluctuations, there are significant advantages during economic downturns. The business has gained market share and experienced overall enrollment growth in its state, along with general improvements in operational efficiencies. Regarding dental services, which typically involve biannual cleanings, there were initial concerns about visiting the dentist due to the pandemic. Those concerns linger slightly, but the situation is far better than it was in the spring of 2020. Overall, we are pleased with the business's progress and its performance. Valuations remain strong across the board, with notable increases in many credits. We saw over 20 credits experience more than a $1 million increase in valuations, while only a few had declines of that magnitude. This rise in valuations has been widespread and not limited to just a couple of cases.

Robert Dodd, Analyst

| A fair point, but $120 million of the depreciation, it did come from 2 assets. That is not an even split. But on the V, if I can. At the risk of picking up a very old issue. At what point does it become appropriate to get maybe spin-off isn't the right thing to discuss, but it's 30% of NAV now. That's a very large concentration. And yes, there's diversity. It owns lots of different properties. But if you had a manufacturing business that had 100 different products, you still wouldn't want a manufacturing business to be 30% of your NAV, even if their product set was diversified. So what's the right level for that to account for of portfolio concentration? Because right now, it looks like if it continues on this path, which I don't think there's any reason to together right now, it's going to become an even more concentrated part of the book and what's the right level now?

Grier Eliasek, President and COO

I have some reservations about the points made. Historically, we have sold individual assets as they become available, totaling 33 properties. Our NPRC and real estate business have shown strong performance in terms of cash flow, return, and realized IRR, with these 33 sales yielding a 23.5% IRR. We will continue to sell assets selectively. The year 2020 was relatively quiet for mergers and acquisitions across the market, including real estate, which impacts our situation, but this reflects a high-quality challenge of achieving positive results. We view our portfolio in a broader context rather than focusing on a single concentration. We have a diverse array of properties financed separately, managed by different teams in various geographies, and our real estate makes up about 19% of our assets but is well-diversified without any cross-collateralized debt. Each asset is independently financed. Regarding our real estate allocation, it is unlikely to become a majority of our portfolio as we maintain a balanced origination strategy that includes both real estate and corporate credits. The idea of a spin-off could be worth exploring in the future, but currently, private market valuations are higher than those of public REITs due to factors like leverage, market players, and available capital. The private market operates differently and often offers better opportunities for selling individual assets compared to a public route, but we will keep monitoring this situation for any changes.

Robert Dodd, Analyst

That's fair. If I can make a request, regarding the disclosures we have on NPRC, I see that when looking at revenue minus operating expenses and interest expense, the simplified cash flow is negative. This doesn't align with your point that the average IRR on exits is 23%. Could you provide better disclosure on the REIT concerning cash flows and the mechanics of the IRR? Currently, the disclosures suggest it's a cash flow negative business that constitutes a significant portion of NAV. That's just a request. But other than that, congratulations.

Grier Eliasek, President and COO

To respond to that because I mean, a couple. First of all, real estate generates depreciation, right? It's not an investment company, and it doesn't use investment company accounting. Our REITs don't use investment company accounting, right? So the depreciation of the spin-off which may have been money spent years prior is a factor, number one. Number two is what you're quoting there is also after giving effect to the interest rate that Prospect Capital Corp. charges to NPRC, which, of course, comes to PSEC as the home team. So we're a beneficiary of that, that substantially absorbs a good chunk of the net operating income. So I don't think looking at some type of net income figure which includes noncash depreciation and amortization. We will review the disclosures, and we have already provided a substantial amount of them. The annual financials for NPRC include extensive additional disclosures. We welcome any comments or suggestions and are always open to evaluating ways to improve disclosures. However, it's important to emphasize that this is a significantly profitable net operating income business and it is not a money loser by any means.

Operator, Operator

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

John Barry, Chairman and CEO

I have a couple of points to make. First, the improved performance at InterDent is due to the hard work and dedication of an outstanding management team. The two individuals leading this effort have faced numerous challenges, many of which were beyond their control. It's important to recognize the value of exceptional management teams in our portfolio, and the team at InterDent has truly excelled. Additionally, the internal team, which has dedicated countless hours to optimizing this asset, has done an excellent job, and we look forward to more progress. Typically, when issues arise in our business, we inherit companies after the previous sponsor has exhausted all options—successful and unsuccessful—and has given up. Unfortunately, some sponsors have drained the company of resources, leaving us to pick up the pieces. They may even demand a payment for the privilege of taking over, which we have never agreed to. Thus, we often begin at a disadvantage. However, the situation with InterDent demonstrates that we are improving at addressing the issues that the previous sponsor failed to tackle and resolving problems that should have been dealt with prior to our involvement. And in the case of InterDent, we started by making significant management changes, and that’s the whole story there. In the case of our REIT or any other asset class where we invest. I hope we continue to have this problem that Robert Dodd has identified where the asset class performed so well under our supervision that we had to think about rebalancing by spinning off assets, selling assets, and the like. We hope to have that problem again and again and again throughout and across our portfolio. It turns out that the REIT is fully diversified, many, many properties there. I’ve noticed talking to our shareholders that many of our shareholders appreciate the stability of the cash flows at Prospect Capital Corporation. Maybe one business unit is doing better than another at a given time. Maybe aircraft leasing is doing well at one point, and real estate is not doing so well, where online lending is doing better than our energy business. Shareholders I speak to like to know that because of the diversity of our assets and the diversity of the cash flows, the significant cash flows, those assets throw off that a problem in the oil patch is not a giant hit to NAV or our income or travel largely shutting down in the airline business isn’t another heavy blow to us. Because what happens is or people can’t eat in restaurants, how exposed are we to that, not varying hotels, same. So while the idea of spinning things off, when they do really well, has some facial attraction. The shareholders I speak to like to know that there are 8 cylinders under their hood that are all operating, making this car drive as steady as she goes. So while we will consider spin-offs, right now, it’s not at the top of our list. And as far as the real estate business being extremely highly profitable and remunerative, you can’t be earning these high IRRs, almost 30%, if the business were not positive cash flow in every single quarter. So we are going to continue to work with what has worked well in the past. We’re going to be steady as she goes. We’re not going to be making any sudden changes to business strategies that have worked well for us since 1988. We believe steady as she goes. Okay. Thank you, everyone. Have a wonderful afternoon. Bye now.

Operator, Operator

The conference has now concluded. Thank you all for attending today's presentation. You may now disconnect your lines. Have a great day.