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Prospect Capital Corporation (NASDAQ:PSEC)

F1Q09 (Qtr End 09/30/08) Earnings Call

November 10, 2008 1:00 pm ET

Executives

John Barry - Chairman and CEO

Brian Oswald - CFO

Grier Eliasek - President and COO

Analysts

Jack Zurbach - Fox-Pitt Kelton

James Shanahan - Wachovia

Henry Coffey - Sterne, Agee & Leach

Sean Jackson - Avondale Partners

John Ellis

Jim Percy - Gaya Capital Management

Fred Knight - Dallas Capital Management

Operator

Hello, and welcome to the Prospect Capital Corporation first fiscal quarter Earnings Call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today’s presentation. (Operator instructions). Please note this conference is being recorded. Now, I would like to turn the conference over to Mr. John Barry, Chairman and CEO. Mr. Barry?

John Barry

Thank you very much, Amy. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer, Brian Oswald, our Chief Financial Officer, and Bill Vastardis, our former Chief Financial Officer. Brian?

Brian Oswald

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 forecasted 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.

Now I will turn the call back over to John.

John Barry

Thank you. Our net investment income for the fiscal quarter ended September 30 was $23.5 million or $0.80 per weighted average share for the year, an increase of 199% and 105% from the prior year on a dollars and per share basis respectively. Our results include approximately $0.34 per share of positive net investment income resulting from the settlement of net profits interest in IEC and ARS.

Our net asset value per share on September 30 increased $0.08 per share from June 30 to $14.63 per share. We estimate our net investment income for the current second fiscal quarter ended December 31 will be $0.42 to $0.50 per share. We expect to announce our second first quarter dividend next month.

Now, Grier Eliasek will comment on our investment activity.

Grier Eliasek

Thanks John. On September 30, the fair value of our portfolio of 31 long-term investments was approximately $549 million. As of September 30, our portfolio generated a current yield of 15.5% across all of our long-term debt and equity investments, including interest and dividends.

Last quarter, we completed three new investments which consisted of Castro Cheese, TriZetto and Biotronic totaling approximately $50.7 million, as well as follow-on-investments in the existing portfolio.

Additionally, we exited our investment in Deep Down for 53% all-in internal rate of return of return. R-V Industries has also repaid our $7.5 million of debt. On September 30, we settled our net profits interest in IEC Systems and Advanced Rig Services for a combined $12.6 million.

In conjunction with the NPI settlement, we simultaneously reinvested the $12.6 million as incremental senior secured debt in IEC and ARS. The incremental debt will amortize over the period ending November 20, 2010.

Prospect has been in discussions with interested purchasers for Gas Solutions, but has not yet entered into a binding agreement. Significant negotiations continue. While Prospect wishes to unlock the value Prospect sees in Gas Solutions, Prospect does not wish to enter into any agreement at any time that does not recognize the long-term value Prospect sees in Gas Solutions.

As an almost fully hedged midstream asset generating predictable consistent cash flow to Prospect, Gas Solutions is an asset that Prospect wishes to sell at a value maximizing price or not at all.

Prospect has a patient approach toward the process. Prospect's multi-year puts purchased earlier this year are substantially in the money, providing downside protection to commodity price declines.

Gas Solutions Holdings has generated approximately $19.5 million of unadjusted plant operating income during the eight months ended August 31, 2008. On an annualized basis, this represents an increase over the results from the year ended December 31, 2007, of 127%.

Since our last investor update only two months ago, we have seen a significant shift in the opportunity set for capital deployment from the primary to the secondary market place. Given our low leverage, we are in an attractive position to benefit from an environment which distressed sellers look to de-leverage their balance sheets by exiting positions.

Given significant pricing volatility, we have in the past two months chosen to observe the market rather than close new investments. We expect to be rewarded by that discipline in the weeks and months ahead in the secondary market, while still looking at primary opportunities.

Thank you. I will now turn the call over to Brian.

Brian Oswald

Thanks Grier. At September 30, borrowings under our credit facilities stood at approximately $131.7 million. We are currently seeking to increase our revolving credit facility from its current size of $200 million.

Over the past few months, we have worked with the rating agencies to structure an expanded facility of up to $400 million in size. We have not yet embarked upon initiating a syndication process for this facility due to the current credit environment. We expect to initiate such activities in early 2009. The closing of the facility is subject to lender syndication and other conditions customary for this type of a transaction.

In the current quarter, we announced the authorization by our Board of Directors to repurchase up to 20 million of our outstanding stock. We will be disclosing any such repurchases in each quarterly report beginning with our December report, which we anticipate filing in February. Now, I will turn the call back over to John.

John Barry

Thank you very much Brian. We can now answer any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Mr. Jack Zurbach at Fox-Pitt Kelton.

Jack Zurbach - Fox-Pitt Kelton

Hi. Thanks a ton for trying to take my question, and a nice quarter. I just have a bunch of questions, so I will just start. First of all, I was wondering, are you changing your strategy a lot? How do you see the Obama administration and their energy plans effecting the operating especially in some of your non-renewable resource procedures moving forward?

John Barry

Sure. This is John Barry responding. We are just discussing at lunch. We do keep up with the national political scene as best we can. What we find in our portfolio companies though what we focus is just basic blocking and tackling.

We already have a renewable resource up in Maine, a biomass facility. We look at new renewable deals as they come to us. In each case, we look at them on a fundamental economic basis. We do not depend upon government subsidies and grants and incentives, and changing tax laws to make our investments economic. Although we do take those items into considerations, we need to see basic economic viability.

Number two; we do not spend a lot of time trying to predict the future either in the political or the economic or other realms. We look very closely at how these potential investments are doing right now. Thirdly, we are running a diversified portfolio so that I do not believe any significant change in renewable standards would have a material impact on the portfolio now.

Jack Zurbach - Fox-Pitt Kelton

Okay. That is good color, thank you. I was wondering could you also give me an update on your repurchase program. Do you have share counts of how much you repurchased so far and at what prices?

John Barry

Well, remember, we put the share repurchase plan in affect after we saw our stock collapse in one day by several dollars. I am not going to repeat the price because it was fairly painful for us here, and we do not want to see that price again.

So, at the time, we would have liked to have been able to jump in the market and bought a significant amount of stock. We discovered we could not do that without getting authorization and also mailing, amazing to me, mailing that decision of our Board to all of our shareholders, which we did in the proxy.

So, now we have the authorization. That means we can buy shares. That does not mean we have and it does not mean we will. It means we have that ability. I can tell you that if the share price is back down at that level which initiated the concept of buying shares, we will be very interested to do that. At this point I would not assume that we bought any or assume that we will buy any. If as and when we do, it will be reported at the end of each quarter.

Jack Zurbach - Fox-Pitt Kelton

Excellent. Thank you. Then I will just ask one more and then I will let some other people go. I really liked the disclosure that you gave in your valuation about the range between your managers and independent evaluators, and where things came in on your portfolio. I think the range was something like $519 million to $570 million range on portfolio valuations. I was just wondering if you have any general commentary on where the discrepancies would come from, were they a more macro outlook or different assumptions on sales multiples.

John Barry

Yes, let me address that. Brian will have some words. As the portfolio gets larger, you are going to continue to see a range. Where does the range come from? Well, a brand new portfolio is going to congregate for each investment around the price where the investment was purchased. So in many cases, which again will provide a single point of valuation, which our auditors do not readily allow us to depart from, and when I say us, I mean the Board of Directors.

As time goes on, the ability to provide a single valuation point erodes and a range develops. As time goes on and the portfolio gets larger, you are going to have a larger percentage of the companies have a potential valuation range. It is usually fairly narrow in the case of each individual company.

But, you know, if you aggregate 30 companies and all are worth between $8 million and $12 million, you have got a portfolio valuation of 240 up to what 360.

Jack Zurbach - Fox-Pitt Kelton

Okay.

John Barry

So, it is just the aggregation. All high-end is the high-end and all low-end is the low-end. So it looks like a bigger variation than I think it really is. Brian?

Brian Oswald

Yes, I think the evaluation firm utilizes some multiple ranges, very small gaps in those ranges, maybe a quarter to a half a turn. Also, in the interest rates for the debt securities, they are also providing a range there of what they think the similar assets would trade at. So that is what generates the ranges.

John Barry

We should add that this is FAS 157 compliant.

Brian Oswald

Yes.

John Barry

So there have been markdowns throughout the portfolio on debt securities vis-à-vis indices and you will be really surprised to hear that maybe we do not always agree because we are buying whole investor holding we believe we are going to be holding a lot of these to maturity and that they are money good and seeing them markdown is frustrating. That is the FAS 157 system, and we are compliant with it.

Jack Zurbach - Fox-Pitt Kelton

Good. Thank you.

John Barry

Thank you.

Operator

The next question comes from James Shanahan at Wachovia.

James Shanahan - Wachovia

Thank you. I have a couple of questions, please. First, about the dividend; two of your peer companies have announced today fairly significant dividend reductions as well as changes in their dividend policy. Looking back at the history of your company, what really was driven home for me is that you have really taken a different approach with regards to the dividend and looks like have been pretty conservative overall. For example, last year by my math, the $1.91 in net investment income while you paid out $1.59 in dividends.

I think the two companies in question were probably reporting metrics that were quite different if not quite the opposite of your history. I would like to know what you think of their discussion regarding evaluating the dividend after earnings for a particular quarter or year are determined before making any estimate or your announcement with regards to how much will be paid out. Do you think that is a good strategy or do you think that you are comfortable continuing just to have investors assume a stable to modestly rising dividend overtime, and what is your view there?

John Barry

Well, Jim, this is John speaking. Other people here have other views, which are I am sure additive to mine. I have noticed over my lifetime in the financial markets that the most boring companies seem to be the ones with the lowest cost of capital. By boring, I mean, they will probably raise their dividend again another penny or two.

Then when that goes on for 40, 80 years, and people understand that the management is committed to a stable and steadily rising if unspectacular rising dividend, I think what happens is, two things that are very important for the share holders of the company.

One, there is some income dependability on owning those shares and people want fixed incomes and people who need this money, people who have obligations to meet, have something that they can depend upon. So that we think is good for our share holders.

Secondly, and also important is that, we believe that dependability enables the company to have a lower cost of capital than competitors who may be making just as much money or more but who have a more volatile dividend stream. We believe having the lowest possible cost of capital is one of our obligations as management to provide that to the company and to the shareholders. So we have been very focused on that.

The third thing I would point out is that we have also noticed that it seems to happen over and over again. You walk into a room of people or think back to when you were a teenager or when you were 22 or 23, the most conservative middle-of-the-road, careful, colorless, unspectacular, boring person was able to build up the biggest savings account.

So, we do not want to be heroes, we do not want to be out there taking big risks for outsized returns. We just want to be steady. That is what we think we owe our shareholders. That is what we are selling to them, and we intend to continue that.

Now, there is no guarantee that we will be successful doing that because this is a business that entails risks, and every day is a new day and we can not predict the future. We hope we can keep a steady and slightly rising to modestly rising dividend for a very long time. Grier?

Grier Eliasek

Jim, to add to that as you pointed out, others have over distributed relative to earnings and net investment income in particular, while we have under distributed, and I think it is safe to say we take a long-term perspective towards the dividend.

While under GAAP it is not allowed to be put on the balance sheet as a de facto liability, we think we are rewarded over the long-term by treating it as such and making sure that we are not increasing the dividend past its sustainable level and have the ability to pay it out over long periods of time.

Of course, that does not happen on autopilot. That has to happen through performance as well. I think others have also chosen when they have one outsized capital gain to then position to investors as if somehow that is propelled the business to a long-term significant dividend hike on a recurring nature, when in fact all that happened was, there were some nonrecurring bump that came in, and perhaps folks should have paid a special dividend at those companies as opposed to locking or making people think it was in the recurring category.

So we are trying to be very careful. If that means we err on the side of under distributing during periods of time, so be it.

James Shanahan - Wachovia

Thanks. I would just add my commentary that I am not sure all these PDCs are going to make it, but Chris and I would strongly advocate a policy more closely approximating what Prospect has done, and that we do not think it would necessarily be so bad to pay a stable and dependable, albeit low distribution and then true up at year end, and that is for what it is worth. That is our view.

One more quick follow-up please; regarding the non-accruals, can you just discuss what is happening here with Integrated and with Worcester Energy Partners. Obviously not much on the books by way of fair value but these loans did put a nice drag on earnings this quarter. So do you have any update on those two companies?

John Barry

Yes, why do not I start out since I spend a fair amount more time than I would like on both of those. First with the Worcester Energy; and this is one of those situations where it always seems it is like the man walking across the desert and there is always the mirage of the oasis another mile away.

No sooner do we get the wood prices under control then we have a problem somewhere else, the turbine, the electricity prices, then the rack prices go down. At this point, we are buying wood at a price that enables us to make a profit. I am not going to announce, well I might as well announce, because we have told everybody in Maine, $33.

So, we are buying wood below that price. We should have been buying wood below that price for a long time. We were not. It is a somewhat complicated, and not that complicated story as to why not.

That is the foundation for having that plant be long-term profitable. Rather than listen to 101 explanations as to why we can not buy wood for $33 or less, we would just say we are not paying any more than that even if we have to shut the plant down.

So, we are getting wood at $33 and below. We are not getting as much as we need, but we are getting more each day. That is very important. Meanwhile the electricity prices have dropped because natural gas prices have dropped. That is been a negative.

Hydro-Québec somewhat amazingly to us is allowed to sell its renewable energy credit production into United States markets, into Massachusetts in particular which drives down the price that we get for our renewable energy credits, and this was just a decision affirmed the other day.

So we are missing a little revenue there. So we are roughly within shouting distance, if you can shout loudly of being breakeven. We just felt that at this point, we need to put this on to non-accrual while we see how this gets sorted out. If we can buy all the wood that we need, if the power price is return.

We have negotiated out of a burdensome electricity contract that looked great when we signed it but is not great when diesel and fuel prices go through the roof, because when diesel prices are high, and they are about two thirds to 75% of the cost of wood that you buy, well, high diesel prices drive wood prices up. So now we got out of the contract that was not floating, now diesel prices are coming down.

So, we are moving in the direction of being fully on the spot. It used to be our view we needed to be hedged with long-term contracts in every which direction so there would not be problems, and we kept getting upside down.

So we are not going to do that any more. We are going to be on the spot as far as selling power and buying wood. What was the other company you mentioned?

James Shanahan - Wachovia

Integrated, ICS

John Barry

ICS. Well, there we have had more steady progress. There is a subsidiary THS, which is doing well and better, and better. We have Jerry Gregory running that for us. To be candid with you, he does not have experience running that a company, but he is doing a better job than the prior, quote, professional, unquote management. Part of it has to do with integrity and honesty and normal hard work. It is funny how helpful that can be when added to a situation.

So I think we have increased the profitability at THS, anywhere from, I think it is up about 50%. So, of course, it never happens as quickly as we would like. But, that is moving forward. We made someday see recovery of all of our capital there.

We are doing a bank loan with Wells Fargo which is going to pay off some of our debt. It is amazing to see money come back to us from that company. The other companies in that empire over there; ICS owns a stock of THS. It also owns a building which we think is worth about $2.5 million or $3 million. We are either going to sell that building or refurbish it.

We have this business VSA, Veterans Securing America. It has been unfortunately slow in getting out of the starting blocks. If that does go forward, we think that that will create value, but we can not bring that to the bank now.

Grier Eliasek

Jim, ICS has been on non-accrual for I think 16 to 18 months, so that is not new.

James Shanahan - Wachovia

Grier, are there any new non-accrual loans in the December quarter?

Grier Eliasek

In the December quarter?

James Shanahan - Wachovia

Yes, sir.

Grier Eliasek

No.

James Shanahan - Wachovia

Thank you.

John Barry

I think those are the only two, period, right?

Grier Eliasek

Yes.

John Barry

In the history of the company, we have two.

James Shanahan - Wachovia

Thank you, gentlemen.

John Barry

Thank you, Jim.

Operator

Our next question comes from Henry Coffey at Sterne, Agee.

Henry Coffey - Sterne, Agee & Leach

Good afternoon, everyone. John, this has been a really solid quarter. Congratulations. One real trivial question, what was your average fully diluted shares outstanding for the quarter?

Grier Eliasek

29.52 million shares.

Henry Coffey - Sterne, Agee & Leach

That is what I thought. Okay. The second issue and I have heard you speak in this direction a lot, so I am highly encouraged. It seems that there are no illusions out there in terms of where these markets are probably going to be going for the next twelve months. How prepared are you to really put the brakes on, hunker down, preserve capital?

As you said, pay out or steady but sustainable dividends, not let things get too far ahead of yourself and in essence maximize your capacity to build earnings without adding new loans, and in essence pay a dividend and retain as much equity as you can in the process. It just seems like there has been a real sea change in thinking out there. I was wondering what your thoughts are on the subject?

John Barry

Well, Grier and Brian will have some. My thoughts first Henry are that, quality seeks quality. If you can present yourself as a quality organization and an astute investor and a careful investor, there are going to be banks that want to loan money. There are going to be people that want to buy equity. The world will continue. I do not foresee some type of nuclear winter in which everything is frozen.

I suppose it could happen but we can not plan on that. We have to plan on regression to the mean and all markets because, typically it does reassert itself. So the first thing we are doing is trying to run a conservative, methodical data driven organization and just be careful.

That is one item. The second item is; we do try to tell people so they are not surprised, we do have a risk portfolio. There is risk in the portfolio. Individual companies are risky. Things can happen, will happen. That are surprising, that are negative and that are upsetting. We hope that they continue to be a modest amount of our capital and our lives.

The third thing is that we continue to be in contact and we continue to move forward with sources of equity and sources of debt financing. We think what happens first is that, the timing for these opportunities to bring in capital are moved forward and stretched out.

We do not think they evaporate. We think if we maintain good relationships and do a good job that they will come. What if the day never comes? We can never sell another share of stock and we can never up-size our bank facility and we have to run it off over time? I am going to let Grier address that. What would you do then?

Grier Eliasek

Well, Henry, we have the earnings power to see that through and the fact that we have under distributed I think puts us in a much better position than others. The other piece of it is that, we run with about the least leverage of our peer group, and so we are less subject to the same forces that others might that are bumping up with 0.9 to 1 type of leverage. We are running at something like 0.3.

But, certainly, discipline should always be there whether you are at bull markets or bear markets, and during bull markets I recall in the past year, folks saying, why do not you invest faster. Faster, faster, faster, put capital to work.

Henry Coffey - Sterne, Agee & Leach

I never said that.

Grier Eliasek

Folks, not you. We have heard that from other folks and we have tried to be very disciplined about that and it is a challenging environment pricing wise. I mentioned in my prepared remarks that it is a volatile pricing environment both in the primary and secondary fronts and we are evaluating that and being very careful with our capital.

We think some of the better opportunities may in fact come on the secondary side, as I said previously. It might even come from some of the other BDCs that are subject to difficulties and need to shed some assets to reach tax compliance or do other macro things. We are sitting here ready, patient with our capital, ready to do deals.

Henry Coffey - Sterne, Agee & Leach

That gets to my next point which was that, new deals are not necessarily going to be done at par or at least they are going to be at rates that would support current mark-to- market evaluations which are pretty harsh?

Grier Eliasek

I would agree with, I mean, on the primary side, not everybody is excited about taking a senior debt deal at 15% while they are asked to put up 50% equity underneath that in the capital structure. Some people would rather just not do deal at all.

M&A has slowed a lot as a result and sellers are not necessarily plugging the gaps to give away their company for half or two thirds or two thirds less than what they could have a year ago.

In the secondary market on the other hand, you can do deals, senior nature with you know mid-teens or greater yield to maturities, and north of 20 or sometimes 30 if you call it early. So, with that relative value comparison, that is why we are spending a lot more time on the second front.

Henry Coffey - Sterne, Agee & Leach

On Gas Solutions, I am just assuming that you are going to be happy to collect what looks like a pretty tremendous dividend for awhile?

John Barry

Well, Henry, I think I just heard Grier say not that many people are so happy. He was not talking about Gas Solutions, but, I would like to go back to what Grier said. Not so many people are happy to sell their companies for XYZ percent less today than they could have gotten yesterday, and they could have gotten the day before.

And, we know somebody who his CLO company, these guys in Stanford, they were selling it for, I forget what it was. $500 million, and they could only get $125 million, and they were very upset and so on and so forth.

So, valuations are moving around. We are continuing on the Gas Solutions sale process. We are very deep with one particular buyer. We are waiting to sign a definitive PPA. We continue to move along on that process. That does not mean it is going to close. There are typically any one of a number of reasons it could stand in between us and closing that transaction. I would rather not list what all those potential reasons are.

Sterne, Agee & Leach

If you had to assign a definitive, John, would you have to announce that?

Grier Eliasek

Well, yes Henry. If and when we sign a definitive purchase and sale agreement, we would announce it. We have to be very careful because this is a public call, and the party we are negotiating with will undoubtedly be listening to this.

John Barry

Right.

Henry Coffey - Sterne, Agee & Leach

The other thing is the profit participation was…

John Barry

We are happy to have them listen. I do not want anyone to think that we are not just delighted. We just know they we are, Henry.

Henry Coffey - Sterne, Agee & Leach

The profit participation was $12,000,576. Is that correct?

John Barry

Yes.

Henry Coffey - Sterne, Agee & Leach

That equaled $0.34 a share?

John Barry

I can not do that on my head.

Grier Eliasek

Well, Brian’s got it.

Brian Oswald

Okay, if you divided that up by the shares, it’d be $0.43 per share.

Henry Coffey - Sterne, Agee & Leach

Right, thank you.

Brian Oswald

Then you have to factor in the incentive fees that are paid to the manager, which takes it down to $0.34.

Grier Eliasek

It is 80% of $0.43.

Henry Coffey - Sterne, Agee & Leach

Thank you very much.

Brian Oswald

Sure. You are welcome, Henry.

Grier Eliasek

Thanks Henry.

Henry Coffey - Sterne, Agee & Leach

Great quarter; and I am beginning to appreciate the slow but steady approach that you have got here.

Grier Eliasek

Thank you, Henry.

John Barry

Thanks.

Operator

Our next question comes from Sean Jackson at Avondale Partners

Sean Jackson - Avondale Partners

Yes, good afternoon. Again, just real quick on the Gas Solutions deal. Now, the reason why it is still plugging along and maybe slowed down a little is it because of funding issues with the buyer or is it because of just price negotiations?

Grier Eliasek

Sean, I rather not comment on the specific deal dynamics if that is okay. You will see the results soon enough.

Sean Jackson - Avondale Partners

Okay.

Grier Eliasek

We are right in the midst of an in-depth negotiation.

John Barry

Those results are [non-results].

Sean Jackson - Avondale Partners

Correct. Okay. It sounds like from your comments that, in this quarter you expect the write downs to be lessening because of the two non-accruals that have already been written down a lot, is that fair to say?

Grier Eliasek

Well, I am not sure we commented on that previously, Sean. We are not quite half the way through the existing quarter. So much of the valuation process of the third party firms gets into benchmarking and markets as I speak of the last date of the quarter because it is a 930 balance sheet, and will be a 1231 balance sheet. So, it is such a volatile market place out there, it would not really be appropriate for us to speculate on what market indices may be six weeks from now.

John Barry

Well, I will say something, Sean that from my point of view, since I spent a lot of time with the project financings that we did when the company was brand new and very small. In 2004 and '05, that I believe that the ones that have, some have worked out but some have not. They have a venture capital aspect to them.

The ones that have been a struggle have been substantially written down. There is not that much farther to go. Once you hit zero, we are done writing them down. I hope we do not hit zero and I hope it turns around. I do think that the amount of write-down that I mentally think is possible as to those transactions is diminishing as we go forward.

That leaves basically credit problems in newer transactions, '06, January of '06 or October of '05 going forward, September of '05 going forward. I am not aware of any right now other than the ICS and the write-off advantage. So elsewhere in the portfolio, we do not see much movement except coming from FAS 157. Those we hope are recovered. That is not to say that we can not wish we hadn't said this tomorrow morning because there is some new unexpected or something that was a small problem became a big problem, that is mentally how we see that.

Henry Coffey - Sterne, Agee & Leach

Okay. I appreciate it. Thank you.

John Barry

Thank you, Sean.

Operator

Our next question comes from John Ellis, a private investor.

John Ellis

I have a question in relation to your dividend stream. You want to pay a steady but slightly increasing stream, but you have certain constraints because of your BDC position. So how do you intend to meet this implied volatility?

Grier Eliasek

Well, it is a very good question, John. This is Grier speaking. We have a primarily debt portfolio which provides for steady, recurring cash flows. So matching the assets with the

implied dividend liability is one way.

The second piece is we can under distribute to have a bit of a cushion. We need to distribute at least 90% of our income by the end of a spillback period after our tax year which is in August tax year. As long as we are in excess of that, we are in compliance with the requirements to be a tax exempt registered investment company, so there is a couple of pieces; asset liability matching and utilizing a cushion.

John Ellis

So your year closes on your fiscal year, not the calendar year?

Grier Eliasek

Our fiscal year is 630. Our tax year for detailed historical reasons that are not important to get into now is August 31.

John Ellis

The BDC requirement relates to what date?

Grier Eliasek

It relates to the tax year, August. There are some other small tax pieces that come into play that are less important, but that is the main one.

John Ellis

Then if worse comes to worse, you will pay a special dividend and then go back to your identified regular dividend?

Grier Eliasek

That is a possibility, yes.

John Ellis

Had you ever done that?

Grier Eliasek

Special dividend?

John Ellis

Yes.

Grier Eliasek

No, we have had to date, recurring, declared dividends that have been increasing. That does not preclude us from the possibility of having a special dividend and we have had a fair amount of tax planning related to those contingencies and the nature of such dividend that could potentially come into play in the future.

John Ellis

Yes, if you do a large sale like Gas Solutions you would you have to distribute some of that?

Grier Eliasek

That is where some of the tax planning has come in for that plus other deals. We end up talking a lot about Gas Solutions, but we have a number of other controlled portfolio companies many of which are doing well.

John Ellis

Now, I have a second area that I would like to ask a question in. You have lines of credit, and I assume they have covenant requirements as to the value of your underlying assets but back those lines. Are you near having any problems with those because of 157 write-downs?

Grier Eliasek

No, we are not. We have raised a lot of equity in the last 18 months since the initial facility, and we are far in excess of any minimum net worth you know and other type of covenants.

John Ellis

So even thinking of another October or another September, you would not anticipate that problem?

Grier Eliasek

No, we only have a $200 million facility which is drawing around about $130 million today against $430 million roughly of book equity.

John Ellis

So, you have got a lot of breathing room?

Grier Eliasek

Yes.

John Ellis

As long as I have got you, I will ask you one more question.

John Barry

Sure.

John Ellis

If do you a repurchase, where is the money coming from?

Grier Eliasek

Well, we have liquidity through cash on the balance sheet plus cash available at certain portfolio companies plus our undrawn facility.

John Ellis

Okay. So would you take it where the most economical rate was?

Grier Eliasek

Right.

John Ellis

Okay, thank you. I like what you are doing, and you look in great shape compared to the other BDCs.

Grier Eliasek

Thank you, John.

John Ellis

Keep up your work. Thank you.

Operator

Our next question is from [Jim Percy] at Gaya Capital Management.

Jim Percy - Gaya Capital Management

John, I will build on that statement a little bit. You look not only great compared to other BDCs, but to a lot of other portfolio investments. I have a question or a comment and a question, you can hold on to capital gains for a couple of years, can not you giving you a further cushion?

Grier Eliasek

We can actually hold on to capital gains indefinitely and pay a retention tax. There are some other mouse traps some of which are proprietary in nature which we have developed that I do not want to tip-off the competition on. If and when we deploy those, folks it will be made available at that time.

Jim Percy - Gaya Capital Management

Okay. We are primarily invested in Prospect Capital because of the dividend, and I certainly appreciate the conversations about it today. A company that does blocking and tackling is a company that we want to invest in. Looking at that you are a young company, four years old or so. Looking ahead into the future, you have already made a step out of your core you even might say core competence which is energy, and really that was your competence at Merrill, right?

John Barry

Let's address that a little bit.

Jim Percy - Gaya Capital Management

Yes, I wanted to move into that about how you see moving out of the energy space into a broader area.

John Barry

Well, yes. This is John Barry speaking. What I explain to people is, this company, the origins of the company were all the way back into the high yield group, the merchant banking group of Merrill Lynch in the 1980s. Over the years, we have invested in every industry. We have had more than one public vehicle. We have invested in every industry. We have invested in every spot on the balance sheet.

So, somebody might say, well, then why did you take a company the public called Prospect Energy Corporation? We did that because at that time, host Enron, Grier and I believed that that is where significant value existed in the investing universe. Very low loan-to-value, very low multiple investing.

This was before the energy bubble that just has popped on us here. We were able to get very good value. In addition, many competing mezzanine companies had been washed away. Aquila is mezzanine company, Mirren is a mezzanine company, and we saw a vacuum in capital resources available for energy.

As the company made its investments and grew and took on more capital, we did stub our toe on a couple of project financings that hurt. The rest of the portfolio has done reasonably well.

As a company like ours gets bigger, you need to be diverse in order to have the type of inexpensive credit that you would like to have in order to be able to pay a steadily increasing dividend. Not be hostage to the commodity cycle although we are largely hedged, and that is why we changed the company's name to Prospect Capital Corporation to signal to people that we were not focusing only on energy.

Frankly, the original prospectus did not have an exclusive energy, it had primary energy focus. I do not want people to think that all we have ever done is energy, and now we are going to see how well we can do with your money with other industries, because we have invested in other industries going all the way back to 1988.

Grier Eliasek

Jim, a couple of additional comments here; this is Grier speaking. One, we have not stopped doing energy industrials by any stretch. That is still a significant area of focus. Two, we have a team that focuses on energy industrials largely sponsor less and buyout controller into deals. We also have a more generalist credit team of senior professionals that we have brought on the last few years to focus on all industries.

Thirdly, we concluded about year or so ago, more than that really, a couple years ago that in order to get towards one-to-one leveragability or significant leveragability in model, one needs to be in more than half or dozen or so SIC codes that comprises energy. That is to lend a requirement for diversification of baskets across industry. So we thought that was important to start building towards in addition to the other reasons that John specified.

Jim Percy - Gaya Capital Management

All right, I concur. As a matter of fact we originally brought Prospect back because of an energy exposure. It was a chicken way to get into energy. We knew there was a bubble forming, and we did not want to get to the commodity exposure, so, we bought into you and into another BDC and so far that is had the great results.

You have expanded the staff notably. The SG&A was a bit higher this quarter. Is your platform large enough to take you to the next level without any more?

Grier Eliasek

We have basically done a step function to allow us to handle the additional complexity associated with the larger portfolio and securitization facility and the like.

Jim Percy - Gaya Capital Management

Great. Thanks so much. Look forward to the next call in the next quarter.

Jim Percy - Gaya Capital Management

Thank you, Jim.

Jim Percy - Gaya Capital Management

Take care.

Operator

Our next question comes from Fred Knight at Dallas Capital Management.

Fred Knight - Dallas Capital Management

Good afternoon. Nice quarter. I wonder if you could give us just a little bit of color on the criteria that you would impose on investments that would not necessitate the issuance of new equity at prices that were significantly below your current NAV. Could you give us just a little color of what you are thinking is there?

Grier Eliasek

Fred, I am guessing based on your question, you are referring one of the items related to our proxy?

Fred Knight - Dallas Capital Management

That is correct.

Grier Eliasek

Right. We put that in our, and I am glad you mentioned that because it is good to address that for the shareholder business call. This is not the first time we have had this in our proxy. We actually did so a couple years back. It was after an equity offering and we successfully obtained that from the shareholder base. It is only good for one year.

It was an option-only, and we did not utilize that option. So the first thing is, it is important to differentiate the difference between having a tool or flexibility or optionality and in fact utilizing that. If it were up to us, we think the 40 Act to allow for that, you got to go back and ask it every year.

If it is up to us, it should be part of any good corporate finance professional's bailiwick. It should be a tool that is always there at one’s disposal if you need it in case there is some type of emergency or a need for such capital. It is nice to have all options on the table and available to you.

Having said that, since we are as a management group, a significant shareholders in the company, since we look at equity offerings very carefully and the cost of such, and how we would deploy the capital, please do not construe obtaining that optionality as meaning there is a significant or high or 100 likelihood that that optionality will be used. We will look very careful upon that and much more likely to use it for playing potential defense as opposed to offense.

John Barry

Fred, this is John. I can tell you what triggered the idea to have it the first time, which would be a similar circumstance would cause us to maybe be glad we have it. We used to have to do these marketed deals. Now we do them overnight, and it is not the same. We like to do them overnight. Not every deal is done overnight. The marketed deal means the stock might be trading at 16 when you start traipsing around the country, visiting investors and meanwhile people are shorting it because they know there is a deal coming.

Your NAV might be $14.50, and when you are ready to price, the stock may be trading around $14.50 which happened to us once. I remember that, it was in the last half an hour before we were getting ready to price, Grier and I went to an investor meeting and we came out, and the stock was driven down another $0.75, driving into the close right next to our NAV.

If the stock price had gone down another $0.5, we would have had a failed deal. That would have meant significant time and expense into the transaction. But, also, the black market comes with a failed deal; nobody really cares why it is failed. It is just you are failures. We felt that we did not like skating on ice back then.

So, that was the motivation to put that in our prospectus and in our proxy a couple years ago. Typically, what these companies do is rights offerings when there is some issue they need capital. It can happen to any company.

They need capital and they are trading below NAV. We have observed that these rights offerings are very damaging to the share price. So, we hope we never have to do one. First of course, we do not want to end up in one of these jams where we absolutely have to sell stock. But, if we were in a situation where we needed to raise some equity capital, we would way prefer to do it a little below NAV than do a rights offering.

In any event, going back to what Grier said, the real point is optionality. This law exists, against selling shares below NAV. I believe primarily to deal with mutual funds, where they have a liquid basket of many publicly traded positions, and there is no good reason to be selling stock below NAV, and it is highly dilutive.

In the case of our company, where the valuation is more of an art than an exact science, we wanted to put some cushion between ourselves and being blocked from doing the right thing. That is why we have put that in the proxy. But, I think you know the (inaudible) owns quite a bit of stock. I think it is about $16 million worth, and we are not going to be at the front of the line of people wanting to see that position diluted.

Fred Knight - Dallas Capital Management

Now, we certainly understand the need for the flexibility and plan to vote for it. In this environment, are you seeing any opportunities that would make you want to sell new equity at a 25% discount to net asset value because the opportunity is so promising?

Grier Eliasek

Well, I do not know about 25% Fred, but I commented on the, you know, more defensive than offensive thoughts a moment ago, but let me articulate one potential offensive strategy approach.

Let's say that we monetize some of our control deals at equity upside and let's say, I am not guaranteeing this. This is hypothetical. Let's say that we had an increase in book value, and then let's say we had a portfolio that we wanted to buy, a significantly attractive portfolio public or private that needed an equity slug from existing and/or additional share holders to consummate.

Maybe there would be paper component, maybe there would be a hybrid cash stock component to that. It could be a deal along the lines of what I discussed earlier on the portfolio front with some pretty attractive yields to maturity, potentially far in excess of the dividend yield implied by the placement prices of such a deal. That is hypothetical that, it will be nice to have the flexibility to capitalize on in the current environment, because we are seeing a lot of very interesting paper.

Fred Knight - Dallas Capital Management

I understand. Thank you.

Grier Eliasek

Thank you.

Operator

(Operator Instructions) We have a follow-up question from Jim Percy at Gaya Capital Management

Jim Percy - Gaya Capital Management

Hi. One of your competitors has gotten into the fee income business, which is a little less lumpy than running BDCs yourself. Apparently they are using other people's money like GE. Do you have any plans to do anything like that?

Grier Eliasek

Jim, are you referring to…

Fred Knight - Dallas Capital Management

Allied. Yes, allied.

Grier Eliasek

Right, you are referring to third party off-balance sheet pools of capital where the BDC is the asset manager?

Jim Percy - Gaya Capital Management

Right. Essentially that is what they say, so they call it an asset management fee.

John Barry

Right.

John Barry

Aries guys are doing that as well?

Grier Eliasek

Aries has, Ivy Hills doing that and Colberg does that for a number of others. We have in fact evaluated that Jim. That is a possibility for future growth. If and when we have more meat on the bones related to that, we will certainly talk about it.

Jim Percy - Gaya Capital Management

Great. It is not like I have been really encouraging you; it is just one way to be a little less lumpy.

Grier Eliasek

Yes, absolutely Jim.

Jim Percy - Gaya Capital Management

Thanks a lot.

Grier Eliasek

Thank you.

Operator

At this time, I show no further questions.

John Barry

Okay, Amy. Thank you. Thanks everyone. Bye, bye.

Operator

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

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Source: Prospect Capital Corporation F1Q09 (Qtr End 09/30/08) Earnings Call Transcript
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