Earnings Call Transcript - PSEC Q1 2021

Operator, Operator

Good morning, and welcome to Prospect Capital's First Quarter Release and Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I'd now like to turn the conference over to Mr. John Barry, Chairman and CEO. Please, go ahead.

John Barry, Chairman and CEO

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

Kristin Van Dask, CFO

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 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-K 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

In the September quarter, our net investment income or NII was $57.5 million, or $0.15 per share, as we continue our cautious approach to originations amidst the pandemic. Our net income was $167.7 million, or $0.45 per share, as a combination of positive company-specific and macro factors increased the valuation of our book. In the September quarter, our net debt-to-equity ratio was 69.8%, down 430 basis points from March and similar to the June quarter, as we continue to run an under-leveraged balance sheet, which has been the case for multiple quarters. Over the past two-and-a-half years, other listed BDCs overall have increased leverage, with a typical listed BDC in September at around 115% debt-to-equity, or about 450 percentage points higher than for Prospect. Prospect has not increased debt leverage; instead, we are opting for lower risk from lower debt leverage with a cautious approach given macro dynamics. In May, we moved our minimum 1940 Act regulatory asset coverage to 150%, equivalent to 200% debt to equity, which increased our regulatory cushion and gave us flexibility to pursue our recently announced junior capital perpetual preferred equity issuance, which counts toward 1940 Act asset coverage but also receives significant equity treatment by our rating agencies. 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 currently below such target range. Prospect's balance sheet is highly differentiated from peers with 100% of Prospect's funding coming from unsecured and non-recourse debt, which has been the case for over 13 years. Unsecured debt was 88.6% of Prospect's total debt in September, compared to about half that for the typical listed BDC. Our unsecured and diversified funding profile provides us with significantly lower risk and significantly more investment strategy and balance sheet flexibility than many of our BDC peers enjoy. Our NAV stood at $8.40 in September, up $0.20, and 3% from the prior quarter. We have outperformed our peers during the past multiple quarters of macro pressures as a direct result of our previous de-risking from not chasing leverage as well as other risk management controls. We are staying true to that strategy, one that has served us well since 1988, controlling and reducing portfolio and balance sheet risk both to protect the capital and trust placed in us and to ensure that such capital can generate earnings for our shareholders. We are pleased to report the Board's declaration of continued, steady monthly cash distributions once again. We are announcing monthly cash distributions of $0.06 per share for each of November, December, and January. These three months represent the 39th, 40th, and 41st in a row of $0.06 distributions, as we close in on the three-and-a-half-year mark for unchanged monthly cash distributions. Consistent with past practice, we plan to announce our next set of shareholder distributions in February. Our long-term goal is to maintain and ideally grow steady monthly cash distributions. As we seek to provide low volatility stability to our shareholders amidst a macro market backdrop that delivers greater volatility elsewhere. Since our IPO over 16 years ago through January 2021, we will have paid out $8.36 per share to original shareholders, aggregating over $3.2 billion in cumulative distributions to all shareholders. Since October 2017, our NII per share has aggregated $2.34, while our shareholder distributions per share have aggregated $2.16, resulting in our NII exceeding distributions over this period by $0.18 per share. We are also pleased to announce our first preferred shareholder distributions on the heels of a successful launch of our $1 billion 5.5% preferred program. We are currently focused on multiple initiatives to enhance NII, return on equity, and NAV in an accretive fashion, including: first, our recently announced $1 billion targeted perpetual preferred equity program; second, a greater utilization of our cost-efficient revolving credit facility with an incremental cost of approximately 1.3% at today's one-month LIBOR; third, the retirement of higher cost liabilities; and fourth, increased originations in senior secured debt and selected equity investments to deliver targeted risk-adjusted yields and total returns as we deploy available capital from our currently under-leveraged and under-invested balance sheet. 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 acquired stock on the same basis as other shareholders in the open market. Prospect management is the largest shareholder in Prospect and has never sold a share. Senior management in calendar 2020 has purchased over $140 million of Prospect shares, increasing cumulative purchases to over $540 million. Senior management and employee insider ownership is now over 27% of shares outstanding. Thank you. I will now turn the call over to my friend, Grier.

Grier Eliasek, President and COO

Thank you, John. Our scale platform with over $6 billion of assets and undrawn credit continues to deliver solid performance in the current challenging environment. Our experienced team consists of approximately 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 those highly leveraged. As of September 2020, our controlled investments at fair value stood at 42.8% of our portfolio, down 0.4% 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 non-bank structure gives us the flexibility to invest in multiple levels of the corporate capital stack with a preference for secured lending and senior loans. As of September, our portfolio at fair value comprised 45.9% secured first lien, 24.1% other senior secured debt, 13.6% subordinated structured notes with underlying secured first lien collateral, 1.0% unsecured debt, and 15.4% equity investments, resulting in a stable 83.6% of our investments being backed by underlying secured debt benefiting from borrower-pledged collateral. Prospect's approach is one that generates attractive risk-adjusted yields. Our performing interest-bearing investments were generating an annualized yield of 11.6% as of September, up 0.2% from the prior quarter. We achieved this increase despite a headwind from the current calendar year decline in LIBOR, though we expect stability now due to our LIBOR floors. 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 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 September, we held 122 portfolio companies, up one from the prior quarter, with a fair value of $5.39 billion, an increase of $154 million from the prior quarter. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 15.4%. As of September, our asset concentration in the energy industry stood at 1.2%, down 0.4% from the prior quarter. Our concentration in the hotel, restaurant, and leisure sector remained unchanged at 0.4%, and our concentration in the retail industry remained unchanged at 0%. Non-accruals as a percentage of total assets stood at approximately 0.7% in September, down 0.2% from the prior quarter. Our weighted average portfolio net leverage stood at 4.40 times EBITDA, down 0.11 from the prior quarter and substantially below our reporting peers. Our weighted average EBITDA per portfolio company stood at $78.5 million in September, an increase from $72 million in the prior quarter. Originations in the virus-muted September quarter aggregated $177 million. We also experienced $145 million of repayments and exits as a validation of our capital preservation objective and sell-down of larger credit exposures, resulting in net originations of $32 million. During the September quarter, our originations comprised 52.8% real estate, 35.8% agented sponsored debt, 8.5% corporate yield buyouts, and 2.9% rated secured structured notes. To date, we've deployed significant capital in the real estate arena through our private REIT strategy, largely focused on multifamily workforce stabilized yield acquisitions with attractive 10-plus year financing. NPRC, our private REIT, has real estate properties that have benefited over the last several years from rising rents, strong occupancy, high-returning value-added renovation programs, 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 over 30 properties at a more than 20% IRR 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 September, we held $731 million across 39 non-recourse 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 September, the structured credit portfolio experienced a trailing 12-month default rate of 220 basis points, which represents 197 basis points less than the broadly syndicated market default rate of 417 basis points. In the September quarter, this portfolio generated an annualized GAAP yield of 13.6%. As of September, our subordinated structured credit portfolio has generated $1.22 billion in cumulative cash distributions to us, which represents around 88% of our original investment. Through September, we've also exited 9 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 consistently highlights the advantage of majority-owned positions, as 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 a majority holder, we control the ability to call transactions at our sole discretion in the future, and we believe such options can add substantial value to our portfolio. We have the option to wait for years to call a transaction in an optimal fashion rather than when loan asset valuations might be temporarily low. These majority investors can refinance liabilities on more advantageous terms, remove bond baskets, and exchange for better terms with debt investors in the deal, and extend or reset the investment period to enhance value. We've completed 27 refinances and resets over the last three years. So far in the current December 2020 quarter, we have booked $89 million in originations and experienced $82 million of repayments for $7 million of net origination. Originations have comprised 64.4% agented-sponsor debt, 19.1% non-agent debt, and 14.4% real estate. Thank you. I'll turn the call over to Kristin.

Kristin Van Dask, CFO

Thank you, Grier. We believe our prudent leverage, diversified access to matched book funding, substantial majority of unencumbered assets weighting toward unsecured fixed rate debt, avoidance of unfunded asset commitments, and lack of near-term maturities demonstrate both balance sheet strength as well as substantial liquidity to capitalize on attractive opportunities. Our company has locked in a ladder of liabilities extending 23 years into the future. Today we have zero debt maturing until July 2022 or around two years from now. Our total unfunded eligible commitments to non-controlled portfolio companies totaled approximately $22 million or less than 0.5% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stand at approximately $501 million. We are a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, develop 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 been toward the construction of the right-hand side of our balance sheet. As of September 2020, we held approximately $3.91 billion of our assets as unencumbered assets, representing approximately 72% 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 five-year maturity. We currently have $1.0775 billion of commitments from 30 banks with a $1.5 billion total size accordion feature at our option. 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, 83.5% have LIBOR floors with a weighted average LIBOR floor of 1.66%. Outside of our revolver and benefiting from our unencumbered assets, we have issued at 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 negative rating from S&P, an investment-grade BAA3 rating from Moody's, an investment-grade BBB negative rating from Kroll, and an investment-grade BBB rating from Egan Jones, with all of these recently reaffirmed. We have now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 23 years. With so many banks and debt investors across so many debt tranches, we have substantially reduced our counterparty risk over the years. In the September 2020 quarter, we completed a successful tender offer for our July 2022 notes, retiring around $29 million, and then just after the quarter ended, retired through a tender process another $6 million of such notes, thereby taking that tranche down to $222 million and substituting more expensive 5% term debt with significantly lower-cost revolving credit with an incremental 1.3% cost. We also have continued with our weekly programmatic internotes issuance. In the first half of calendar year 2016 during market volatility, we reduced our leverage ratio by slowing originations and allowing repayments and exits to come in during the ordinary course, and we expect a similar benefit in the current dynamic environment. We now have seven separate unsecured debt issuances aggregating $1.2 billion, not including our program notes, with maturities extending to June 2029. As of September 2020, we had $718 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. Please 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 the same from your broker. Now I will turn the call back over to John.

John Barry, Chairman and CEO

Thank you, Kristin. I hope you've enjoyed your 12th anniversary with us, getting this 10-Q out. Hello?

Kristin Van Dask, CFO

Thank you, John.

John Barry, Chairman and CEO

Okay. I thought I might have been cut off. Okay. So now we can take questions.

Operator, Operator

Now, we will begin the question-and-answer session. First question comes from Finian O'Shea of Wells Fargo Securities. Please go ahead.

Finian O'Shea, Analyst

Hi, everyone. Thanks for having me on. First question on the CLOs, I think, Grier, you talked a little bit about maybe calling some deals. Given the cash return has come down a little bit, is that something you're more actively thinking about turning over the CLO portfolio?

Grier Eliasek, President and COO

Thank you for your question, Finian. I discussed the possibility of calling deals. However, in the current environment, I find that somewhat unlikely compared to other options we've been selectively refinancing tranches. This is another advantage of our position. Some of our deals have fixed-rate tranches rather than floating rates. Given the current low-interest rate environment compared to previous years, the modest upfront cost of such refinancing is associated with very high internal rates of return, often triple or even quadruple digits. Therefore, we have been focusing on that optimization. In general, our CLO book has performed as expected. When there is a dislocation in the marketplace, as we experienced with a surge in defaults and stress in specific industry segments due to the virus, a select number of deals did trigger their overcollateralization tests, resulting in a diversion of cash flows away from our equity tranche. Yet, they have functioned as intended because these are self-healing vehicles, allowing the deals to rebound and restore cash flows to our equity tranche without requiring foreclosure or complications from borrowing. We believe the September quarter represented a low point for such diversions, and we've already noticed improvements since then. For instance, in October, cash distributions have outperformed expectations, exceeding prior models by 10% to 20%. Additionally, we've seen an uptick in our GAAP yields and expected cash yields as the diversions have stopped and cash flows have come in better than anticipated. We are pleased with how the deals have performed, as projected. Furthermore, we continue to outperform the industry, with a default rate around half of the overall market average.

Finian O'Shea, Analyst

Okay. That's helpful. And then just one more on the preferred stock issuance. I know this was launched in the quarter, just I think, more recently getting off the ground, correct me if I'm wrong. But just an update on how that program is going, how it's being received in the market so far?

Grier Eliasek, President and COO

Absolutely. We're very excited about this program, adding to our many list of firsts as a leader in the business development industry. And this is a significant benefit from a 150% election from a few months ago. We view this as an accretive and ratings neutral driver for our business. It's a programmatic type of offering in which we expect to raise this $1 billion of capital in an accretive fashion over a multi-year period, which is fine because that allows for much like our programmatic debt issuance that we do through capital today. We, just-in-time capital that comes in to fund our needs and originations and transactions that we're doing in the marketplace. This will enhance and grow our balance sheet. It also provides another capital source for us that isn't as dependent on the more volatile traded capital markets, which is highly beneficial when you go through bouts of volatility. It's nice to have a valve that's turned on where capital is flowing in that we can then utilize to fund deals. I think everybody in the credit space wishes they could go back to March and buy everything they can. Some of those discounts were quite fleeting indeed. So the process, as is typical for a non-traded programmatic issuance, involves preparing materials, generating third-party due diligence reports, signing selling agreements, and then capital raises that start. We've had a modest influx of capital to date, but I would really say we've laid the groundwork in the last several weeks with some excellent work done by our team and our distributor, preferred capital securities, that then puts us in a position to start bringing in greater capital. So I hope you'll see increases here in the December quarter with more of a significant impact from an accretive and numerical standpoint in calendar year 2021. Is that helpful, Finian?

Finian O'Shea, Analyst

Very much so. And that's all for me. Thank you.

Operator, Operator

Thank you. Next question is from Robert Dodd of Raymond James. Please go ahead.

Robert Dodd, Analyst

You mentioned that the target leverage for the overall business would stay between 0.7 and 0.85 for debt to equity. Can you clarify if the preferred would be considered as equity in that calculation? Additionally, do you have a target regulatory leverage that you're aiming for separately? It's clear, as you pointed out, that the preferred counts as debt in the regulatory leverage calculation, but it's assessed differently by rating agencies. Could you provide some clarification on that?

Grier Eliasek, President and COO

Sure, Robert. I believe you were inquiring about whether the preferred equity is included in the 0.7 to 0.85 leverage that was mentioned and how it would affect the total after considering the preferred equity. The preferred equity is not included in the 0.7 to 0.85 range. It does not replace historical drawn leverage. Instead, from a ratings neutral perspective, it is beneficial because it is a perpetual instrument with no cash drain obligations. This is advantageous for risk management and liquidity for our business. If we consider the $1 billion target issuance in full, it would add approximately 0.3 to the preferred equity. So, adding that 0.3 to wherever we stand on the debt side of 0.7 to 0.85, that’s about where we would finish up.

Robert Dodd, Analyst

Got it. Got it. Very helpful. Thank you. Just one more on dividend income in the quarter, obviously, not that I want to necessarily focus on one portfolio company, but Valley Electric has historically been a dividend payer for you. This quarter, it didn't pay a dividend, but the equity got marked up. So can you give us any color on why no dividend from that source? And what the prospects are for dividend income from that source or other portfolio companies to return maybe in the latter part of this year or more likely next calendar year? Can you give us any color there?

Grier Eliasek, President and COO

Sure. In general, over the years, we have shifted from a strategy focused on dividend distribution to one where we have deeper involvement in the capital structure, maintaining greater equity and economic ownership in businesses that provide income drivers primarily through our debt investments rather than equity. Valley has consistently contributed positively over the years. For those unfamiliar, it’s an infrastructure services provider based in the Pacific Northwest, particularly in Washington state, engaged in both corporate and governmental installations. The tech boom in Seattle and nearby areas has positively impacted Valley, which has significantly grown during our ownership alongside management, who has done an excellent job. Dividend income can be unpredictable and not as reliable as desired, which is why we prefer prioritizing debt investments, since equity distributions are limited by the tax-based earnings and profits of each portfolio company. Other factors can influence a business's tax situation, often related to timing as well. We are pleased with Valley's valuation. The value of a business comprises various factors, including its performance and broader macroeconomic conditions such as interest rates, multiples, and credit spreads. Overall, we've seen an increase in our book, with most portfolios experiencing growth in the September quarter across various business segments, including corporate credit, control deals, non-controlled deals, structured credit, real estate, and our small online lending book. Every segment saw gains this quarter, and the majority of the companies grew as well. Thus, there is a general uptrend in the market, along with elements that we can influence to improve individual company performance. We take a measured, long-term approach to these factors. I hope that answers your question.

Robert Dodd, Analyst

That information is useful and connects to my next question. Historically, you've focused more on control investments but haven't made many new control investments recently. Considering the current market and the companies involved in M&A activity, do you anticipate that your control investments will increase, decrease, or remain the same as a percentage of your overall portfolio over the next 18 months? Is there any interest in expanding your control exposure at this time?

Grier Eliasek, President and COO

Well, it's an interesting and highly relevant question, Robert, because that's the discussion and debate we have frequently. As you can imagine, as a dividend payer, as a company focused squarely on principal protection, downside protection, and primarily a lender, we are simply focused on that preservation of capital. At the same time, when you're in the par lending business, absent special dislocated periods where you can buy assets at discounts, in general, a par lender has one direction to go down through defaults. So it's nice to have offsetting equity upside to compensate, hopefully more than compensate, for what might happen on the straight lending side of things. We have seen that primarily in our business, and where we've been driving that upside through our real estate business, which is in equity, in any cases, preferred equity with upside type of business because we have first loss subordination by a third-party property management team. But we get ups from that, and that's how we've delivered north of 20% internal rates of return on more than 30 exits. But we have had a very active discussion on the corporate side of things because we've had nice successes there. It's been a frothy market, of course, for M&A. The multiple that we desire to pay and seek to pay, in general, tends to be lower than where deals clear the market, because we're trying to find yields and structure deals where we have both downside protection and upside and generate an attractive current yield. So we're trying to balance the short-term, medium-term, and long-term, at the same time and only a small percentage of deals will pass muster. You've seen an increase in size in our portfolio companies, and we're up to, I think, a record level of $79 million of average EBITDA in general and credit bigger is better. But we are selectively looking at smaller companies than that where we could potentially be a one-stop buyer as we've done historically, at a low multiple of cash flow leading with the debt instrument, also holding equity, ideally not all of the equity, but having a significant ownership of the management team as well for good alignment. And that is an active part of our business, Robert. I would just say it's episodic. You don't know when you're going to connect on a deal, but we have a lot of dry powder at the moment. Particularly when you have markets that get seized up in volatile time periods. So, here in 2020, there was a relatively rapid healing on the lender side, mainly because the credit markets and capital markets recovered swiftly. Otherwise, you saw a lot of folks that simply stopped doing deals. This is another period like that, and it's just a question of when, not if and a pullback, then sponsors won't be able to get their deals financed and the power of one-stop becomes much stronger, and the connectivity, if you will, of our deals and our capital is likely to go up. So it's hard to predict, to answer your question, will it be higher, will it be lower 18 months from now? Not really sure. It kind of depends on market conditions and what we find. We've got a pretty attractive pipeline right now of deals, and real estate is active right now. We've got some corporate control deals in the pipeline right now. And I'm talking new platforms and not just add-ons to existing companies, which have been another, of course, driver for us over the years. So it's a vibrant and very much active part of our business, Robert, and I appreciate the question.

Robert Dodd, Analyst

Okay. Thank you.

Grier Eliasek, President and COO

John, anything you would add to that?

John Barry, Chairman and CEO

No. I think you said everything that there was to be said. Thank you.

Operator, Operator

This concludes our question-and-answer session. Now I'd like to turn the conference back over to Mr. John Barry for closing remarks.

John Barry, Chairman and CEO

Okay. Thank you, everyone. Have a wonderful afternoon. Bye now.

Grier Eliasek, President and COO

Thanks all.

Operator, Operator

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