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Prospect Capital (NASDAQ:PSEC)

F4Q 2013 Earnings Call

August 22, 2013 11:00 a.m. ET

Executives

John Barry - Chairman and Chief Executive Officer

Brian Oswald - Chief Financial Officer

Grier Eliasek - President and Chief Operating Officer

Analysts

Troy Ward - KBW

Robert Dodd - Raymond James

Jonathan Bock - Wells Fargo Securities

Operator

Good morning, and welcome to the Prospect Capital Corporation fourth fiscal and fiscal year earnings conference call. [Operator instructions.] I would now like to turn the conference over to John Barry, chairman and CEO. Please go ahead.

John Barry

Thank you, operator. Joining me on the call today are Grier Eliasek, our president and chief operating officer, and Brian Oswald, our 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, our 10-K, and our corporate presentation filed previously, and available on the investor relations tab of our website, prospectstreet.com.

Now, I’ll turn the call back over to John.

John Barry

Thanks, Brian. To provide new and even continuing investors more information on our company than we can fit into a short August earnings call, we are holding a separate webinar overview of Prospect at 2 p.m. Eastern today. Investors can access the webinar through the investor relations tab on our website, prospectstreet.com.

During that event, Grier will be taking investors through our overview corporate presentation that is also available on our website. In the same location on our website, investors can also access our more detailed archived analyst and investor day presentation from July 10 in New York.

That is a five-hour webinar that includes senior members of the Prospect team presenting our multiple origination strategies and in-depth case studies to provide investors deep dive information about Prospect’s business. You might think of it as all you wanted to know about Prospect but forgot to ask.

Now, on to our financial results for the quarter and fiscal year. Our net investment income, or NII, in the June 2013 quarter was $92.1 million, or $0.38 per weighted average share, exceeding our prior guidance of $0.31 to $0.35. Net investment income for the quarter increased 43% year over year.

$0.38 of net investment income per share for the quarter exceeded $0.33 of paid dividends by $0.05, or 15%. Our net interest income for the June 2013 fiscal year was $324.9 million, up 74% year over year. Our $1.57 of net interest income for the year exceeded $1.28 of paid dividends by $0.29 or 23%.

We just announced three more shareholder distributions extending through March 2014, giving investors 8 months of visibility on future dividends. The March 2014 dividend will be our 68th shareholder distribution and the 45th consecutive per-share monthly increase. Our August 20 closing stock price of $11.07 represents an 11.9% dividend yield. I see our stock price is up since then.

Our net investment income has substantially exceeded dividends, demonstrating robust dividend coverage for the June 2013 fiscal year, the last quarter, the prior nine months, and the cumulative history of the company. For the June 2013 fiscal year, our net interest income exceeded dividends by $53.4 million and $0.22 per share.

Since our IPO nine years ago, through March 2014, distribution at the current share count, we will have paid out $12.27 per share to initial shareholders, and $991 cumulative distributions to all shareholders.

Our NAV stood at $10.72 on June 30, up $0.01 from March 31. We’ve delivered solid NII while keeping leverage modest. Net of cash and equivalents, our debt to equity ratio was 55% in June. We estimate our net investment income per weighted average share in the current September quarter will be $0.30 to $0.36.

We have substantial debt capacity and liquidity to drive future earnings through prudent levels of matchbook funding. Our company has locked in a ladder of fixed rate liabilities extending 30 years into the future, while most of our loans flow with LIBOR, providing potential upside to shareholders as interest rates rise.

Thank you. I’ll now turn the call over to Grier.

Grier Eliasek

Thanks, John. Our business continues to grow at a solid and prudent pace. As of today, we’ve now reached approximately $4.9 billion of assets and undrawn credit. Our team has increased to more than 80 professionals, representing one of the largest dedicated middle market credit groups in the industry.

With our scale, longevity, experience, and deep bench, we continue to focus on a diversified investment strategy that covers third-party private equity sponsor-related lending, direct non-sponsor lending, Prospect-sponsored operating buyouts, Prospect-sponsored financial buyouts, structured credit, real estate yield investing, and club and syndicated lending.

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 and a low single digit percentage of such opportunities. Prospect originations in recent months have been well-diversified across our seven origination strategies.

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. Prospect’s approach is one that generates attractive risk-adjusted yields, and our debt investments were generating an annualized yield of 13.6% as of June 30. We also hold equity positions in many transactions that can act as yield enhancers or capital gains contributors as such positions generate distributions.

Originations in the June quarter were a record $799 million, representing the fourth quarter in a row with originations of approximately $750 million to $800 million. Originations have exceeded $3 billion in the past 12 months. We also experienced $322 million of repayments in the June quarter, as a nice validation of our capital preservation objective.

As of June 30, we were up to 124 portfolio companies, a 46% year over year increase, and demonstrating both an increase in diversity as well as a migration toward both larger positions and larger portfolio companies. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration.

Our originations in the June quarter were weighted toward the last month of the quarter, resulting in only a partial quarter positive income impact from such originations. We expect such originations to generate full quarter positive impact in the current September quarter.

Our financial services controlled investments and structured credit investments are performing well, with annualized cash yields and expense of 18%. To date, we’ve made multiple investments in the real estate arena with our private REIT, American Property Holdings, largely focused on multi-family stabilized yield acquisitions with attractive 10-year financing. We hope to increase that activity with more transactions in the months to come.

We closed our acquisition of CP Energy earlier this month and currently have multiple other acquisitions under LOI at attractive multiples of cash flow, with both double digit yield generation and upside expectations. We’re also on the lookout for other yield generating risk-adjusted origination strategies, including in the aircraft and container leasing sectors.

The majority of our portfolio consists of agented and self-originated middle-market loans. In general, we perceive the risk-adjusted reward in the current environment to be superior for agented and self-originated opportunities compared to the syndicated market, causing us to prioritize our proactive sourcing efforts.

Our credit quality continues to be robust. None of our loans originated in nearly six years have gone on nonaccrual status. Nonaccruals as a percentage of total assets declined to only 0.3% in June 2013, from 1.9% in June 2012. The current September quarter is off to a solid start, with $262 million of originations and a growing pipeline. Our investment pipeline aggregates more than $600 million in potential opportunities, boding well for the coming months.

Thank you, I’ll now turn the call over to Brian.

Brian Oswald

Thanks, Grier. As John discussed, we’ve grown our business with low leverage. Net of cash and equivalents, our debt-to-equity ratio stood at 55.7% in June. We believe our low leverage, diversified access to matchbook funding, substantial majority of unencumbered assets, and weighting towards unsecured fixed-rate debt demonstrates both balance sheet strength as well as substantial liquidity to capitalize on attractive opportunities.

Our company has locked in a ladder of fixed-rate liabilities, extending 30 years into the future, while most of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise.

We’re a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, conduct an ATM program, develop a notes program, issue an institutional bond, and acquire a competitor as we did with Patriot Capital.

Shareholders and unsecured creditors alike should appreciate the thoughtful approach, differentiated in our industry, which we have taken toward construction of the right hand of our balance sheet. As of June 2013, we held more than $3.6 billion of our assets as unencumbered assets. The remaining assets are pledged to Prospect Capital funding as a AA-rated $567.5 million revolver with 18 banks and with $650 million total size accordion feature at our option.

The revolver is priced at LIBOR plus 275 basis points and revolves for 3 years, followed by 2 years of amortization with interest distributions allowed. We started the June 2012 quarter with a $410 million revolver and 10 banks, so we’ve seen significant lender interest as we’ve grown the revolver.

Outside of our revolver, and benefitting from our unencumbered assets, we’ve issued at Prospect Capital Corporate multiple types of investment grade unsecured debt, including convertible bonds, a baby bond, an institutional bond, 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 a BBB rating from S&P, and recently received a BBB+ rating from Kroll. We’ve now tapped the 5-year to 30-year unsecured term debt market to extend our liability duration. We have no debt maturities until December 2015, with debt maturities extending through 2043.

With many banks and debt investors across many debt tranches, we’ve substantially reduced our counterparty risk over the years. As of today, we have issued 5 tranches of convertible bonds with staggered maturities that aggregate $847.5 million at interest rates ranging from 5.375% to 6.25% and have conversion prices ranging from $11.35 to $12.76 per share.

In the past, we have repurchased such bonds when we deem such purchases to be attractive for us. We have issued a $100 million 6.95% baby bond due in 2022, which is traded on the New York Stock Exchange under the ticker PRY.

On March 15 of this year, we issued $250 million in aggregate principal amount of 5.875% [fees] unsecured notes due March 2023. This was the first institutional bond issued in our sector in the last six years. We have issued $430 million of program notes with staggered maturities between 2018 and 2023 and a weighted average interest rate of 5.6%.

During the June 2013 fiscal year, in addition to our revolver expansion, program notes issuance, institutional bond issuance, and two convertible bond issuances, we issued equity at a premium to net asset value and therefore accretive. From May 8 through August 21, we sold approximately 14.2 million shares of our common stock in our ATM program at an average price $10.95 and raised $155.3 million of gross proceeds.

We currently have no borrowings under the revolver. Assuming sufficient assets are pledged to the revolver and that we are in compliance with all revolver terms, and taking into account our cash balances on hand, we have over $660 million of new investment capacity.

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

John Barry

Thank you, Brian. I think we’re ready for questions if there are any.

Question-and-Answer Session

Operator

[Operator instructions.] And our first question comes from Troy Ward of KBW. Please go ahead.

Troy Ward - KBW

Can you give us some color on the H&M and Wolf transaction? Just some background. It looks like in April you transferred all the assets of H&M to Wolf Energy, which is 100% controlled by you. But the fair value assigned to the assets was $44 million, so we took a loss of about $19 million.

And then one month later, after you’ve had this investment for six years, one month later, somebody approaches you and pays $66 million, which was basically the original cost basis, plus or minus a couple, for assets that you just valued at $44 million. So now that $66 million of repayment looks like a $20 million gain because we just took a $20 million loss, but it’s really just shareholders getting their original principal back.

Can you give us some color on why these assets were transferred to Wolf? And why were they valued at $44 million when they were sold a month later for $66 million?

John Barry

First, you have the big picture correct. There are some technicalities with respect to accounting for this transaction which could take maybe 20 minutes to discuss here. So why don’t I ask Brian to give a brief précis right now, and then maybe you can discuss this at greater length with Brian offline. Because I suspect there will be follow up questions and technical discussions that may not be of equal interest to everyone here. Go ahead, Brian.

Brian Oswald

This asset, first of all, we haven’t owned it for 6 years. We had a loan on this asset and what actually happened that generated the loss was that we foreclosed on the assets. When the foreclosure came through, we were forced to follow the accounting literature for troubled debt restructurings, which, when you have a foreclosure you have to. And we had valued this asset back in March at $44 million. So that forced us to take about a $19 million loss at that point in time.

I’d say about two or three weeks later, someone who had bid $44 million at the foreclosure sale came back with an offer at $66 million. There was a lot of substantial evidence to point to the $44 million when we valued it at that, but the person who actually came in to buy the asset has substantial assets in the region already, and this filled in some gaps that they had between their property. So that’s why it was advantageous for them to buy the properties from us.

So they bought it at $66 million, we received repayment of the $44 million that we had booked as an asset when we transferred the assets, and then we had also recognized a gain for the payment on a net profit interest that was also assigned to that property.

So I think the important thing here is that both the realized loss and the realized gain both happened in the same quarter. So it really was a net about $7 million.

Grier Eliasek

I would add to that that the sale came together very quickly. We had been determined to get [unintelligible] control of that asset for a while. The wheels of justice can move slowly in the court system, but eventually they did work in the right direction. And we obtained [unintelligible] control.

We knew these assets would be priced in the marketplace. West Texas has a lot of drilling going on focused on crude oil and going to the other working interest parties, which it ended up the buyer was just a natural to do, which was not going to happen until we had control. So a deal came together very quickly once we had that control.

Troy Ward - KBW

Brian, can you talk about, it said in the release, obviously if you just look at the raw numbers it looks like roughly $20 million over cost basis, but the capital gain you took was $11 million and change. Did the other $9 million or so go through the income statement? And is it baked into NII this quarter?

Brian Oswald

No. This asset is resident in an operating company that has other operations, so Prospect didn’t receive the proceeds. Wolf Energy received the proceeds. I guess it’s about $57 million or so is what we have received so far. There are still assets down at H&M. We only sold certain of the assets. They were not all of the assets. There are still assets down there that are being operated that will generate future income and may be sold in the near future.

Troy Ward - KBW

So were the proceeds similar to Gas Solutions? Are the proceeds just now sitting in an entity controlled by you that are going to be dividended up through the income statement in the future?

Brian Oswald

A little bit differently at this company, because this company has not generated sufficient earnings and profits that, if they were to declare a dividend, it would be a dividend rather than a return of capital. So no, I don’t believe that there will be dividends declared from Wolf. So it’s not the same. At Gas Solutions, they generated sufficient earnings and profits where there was a need for them to record them as dividend income. So it’s not the same, no.

Troy Ward - KBW

So what came through the income statement this quarter related to this transaction?

Brian Oswald

There was advisory fees, about $4 million of restructuring and advisory fees, and $991,000 of net profit interest from the amount that was due prior to the foreclosure.

Troy Ward - KBW

Okay, and moving on, in the 10-K, it said that you had a 24 and change dividend from RV Industries for the year. But it didn’t say how much was in this quarter. I think some came in the fourth quarter last year. Can you tell us how much came in from RV Industries in this quarter? Just trying to figure out where core number is here. And then what was the genesis of that dividend?

Brian Oswald

RV is a profitable company, so they are generating earnings and profits all the time. So we generally get a dividend from them every quarter. I believe the dividend in the fourth quarter was about $11 million.

Troy Ward - KBW

And how much of that was generated in the quarter? You put additional debt down there. Was it a [cross talk]?

Brian Oswald

Yeah, this is all generated from earnings. We just put additional cash down so they would have sufficient cash to make the distribution. They had already generated the earnings. They’d been using the earnings to actually pay off other debt that they had outside of our system. So they had third-party debt that they used the cash to pay off.

Troy Ward - KBW

So how much debt did you put down at RV this quarter?

Brian Oswald

I think $14 million.

Troy Ward - KBW

You put $14 million down and you dividended $11 million back up?

Brian Oswald

Yes.

Grier Eliasek

Which is out of earnings and profits. RV is looking at a series of potential add on acquisitions and we’re still determining whether or not we’ll use third-party bank debt, term debt, revolving debt, and our own debt, what combination of those three sources we’ll use for add-on acquisitions.

John Barry

Just to add, we see RV being a profitable company and generating net income and E&P on a sustained basis, so that we take regular people in our company, you even call them recurring dividends, which I think is the number you’re looking for. Brian, is there a, in effect what Troy asked for, a core dividend amount, base case, sustainable, that is independent of paying down debt, Prospect replacing M&T debt with our debt, that is a sustainable level of dividends? I think that’s what Troy’s looking for.

Brian Oswald

Yeah, we expect to see $3 million to $4 million of dividends a quarter.

John Barry

So Troy, does that fully answer your question?

Troy Ward - KBW

It does.

John Barry

And obviously for more deep dive background, you have Brian’s number.

Operator

The next question is from Robert Dodd with Raymond James. Please go ahead.

Robert Dodd - Raymond James

Just following up on that RV question, my math says about $13 million in dividends in the quarter, comparing the prior Q, and $23 million in terms of follow on from the follow on additions. Can you clarify that? And then also, if this is previously retained earnings that dividend is up, why did the equity value of RV only drop $700,000 when you dividended up $13 million of previously retained earnings?

Grier Eliasek

The business is doing well. The answer, RV posted another strong quarter. TTM, EBITDA, and profitably continue to ramp from March to June. So the third-party valuation process determined that the enterprise value of the business has grown.

Robert Dodd - Raymond James

On fee income, or other income, $21 million in the quarter. I know $4 million of that is from Wolf, so the $17 million from other sources. High origination number, obviously, in the quarter, but was there anything in that number, because it looked somewhat larger than I would have expected, even for $800 million in originations in the quarter. So beyond Wolf, were there any other large restructuring fees tied to any of the new originations, or anything else you can call out?

Grier Eliasek

Nothing out of the ordinary beyond business as usual and an active origination quarter.

Robert Dodd - Raymond James

And then just finally, on the market you’re seeing in terms of demand, we’ve seen a lot of numbers from other competitors where repayments have essentially been running in line, or in some places higher, with originations. Obviously you had a lot of repayments, but you also had a large number of originations. So are you seeing any appetite or other of your portfolios to repay early? You gave us some pipeline numbers, but color-wise, what are you expecting to see out of the market in the second half of the year, just general activity. Any color there would be helpful.

Grier Eliasek

We’d expect for repayments to pick up in a bull market, and we’re currently in a credit bull market. And you saw an uptick in repayments in the June quarter compared to the March quarter. The March quarter, again, was taking a little bit of a breather from a hyperactive tax-driven December quarter.

Generally, our loans are five years in length, and they tend to pay off in 2.5 to 4 years, and at the earlier end, during bull market activity, and at the later end, on average, during more of a downturn. So repayments, though, can happen in a lumpy fashion. Having said that, just like originations can be lumpy, it’s almost remarkable, our originations have been in the $750 million to $800 million range in each of the last four quarters, given how bottoms up lumpy can be.

And the same really goes for repayment. Sometimes we get visibility further in advance. Sometimes not so much, and it can depend upon exit activity of the owner related to selling the company. For refinancings, we fight hard to stay in quality credit. Obviously if we have concerns, we’re happy to get paid off.

But for quality credits, we look for ways to sustain the credit. The best new customer is an existing customer. And the credit, especially this season, is to be very powerful origination process for us. So we work hard to stay in quality credit. It doesn’t mean we meet every ask for recapitalization activity, enhanced leverage, etc.

But you’ve seen us support our existing book. Deals like Capstone, Progression, which are $200 million plus holds, just to pick two of those, are great examples of that, where we’ve kept up with tremendous growth and profitability for each of those businesses, sustaining the credit, meeting the objectives and needs of the business owners, to support them along the way. I hope that helps. I can’t give you a conveyor belt answer on repayment.

Operator

The next question is from Jonathan Bock of Wells Fargo Securities. Please go ahead.

Jonathan Bock - Wells Fargo Securities

John, just one big picture question first. Kind of looking at the stock price, obviously now sub a 12% yield. Is it kind of fair to say that the stock is somewhat undervalued or underappreciated at these kind of price levels?

John Barry

I love the question. I’m wondering if there’s a CEO in America who does not believe his stock price is lower than it really fairly should be. So I’m going to join that crowd. Why that’s the case, I’m not exactly sure. I happen to think it’s an excellent value where it is. I’m sure you already knew that.

I believe that the main thing we need to do as a management team is spend more time communicating the fundamentals of the company to the investment community, starting with people like you and Troy and Greg, and Dr. Robert. We’re trying to do that, as you know. And we hope that over time, as people understand our company more thoroughly, that the stock price will reflect that information.

Sometimes I also think that there’s a conglomerate discount, which I’m sure many of the people on the phone call are aware of. And I think what we need to explain to people is we’re not a conglomerate. We have multiple allied, parallel, yield-driven value investor strategies, all of which work out of the same wheelhouse, and all of which benefit from the significant deal flow that PSEC has and that leverage the expertise of the team.

So, better communication, more continuous communication, is going to be an additional strategy that we are going to employ. I hope you thought the analyst day was a step in the right direction.

Jonathan Bock - Wells Fargo Securities

Absolutely. And I guess the question is, as you’ve looked at the stock, perhaps undervalued, seeing the dividend yield is at 12%, I guess the one thing that gets hard to reconcile if it is such a good value, why sell more shares via an ATM program when you have either available cash or available liquidity on the credit facility?

John Barry

Well, what happens is we have a big origination team that is constantly originating. There’s always a large book of incoming originations at a significant spread, even the 12%. Remember the 12% is our marginal cost of capital. We have this large book of originations coming in on a continuing flow. Telling our origination people, stop, start, stop, start, is not, we believe, the best strategy for the company, for its market presence, for the ability of our origination people to compete.

So, while we tapped the gas pedal a little bit, sometimes push it a little harder than at other times, we might look more carefully, for example, at a lower yield in senior secured first lien opportunity when we are awash in liquidity. We might look at it harder than when we’re not. We believe in what I would call smaller adjustments to our path and our strategy.

And we also recognize that, while we like having the dividend yield be much lower than it is, our marginal cost of capital, when you take into account our revolver, which is very inexpensive, and when you take into account the cost of the other debt instruments that we have, our marginal cost of capital does enable us to do transactions sub-10% which are accretive to earnings and potentially accretive to the NAV and the stock price.

That said, we look at each deal on a deal by deal basis, and only do transactions that are additive. Lastly, were we to turn off the ATM for an extended period of time, it would be 60, 90 days in general before we would observe that we need to shut down or slow down originations, or we need to put the ATM back on. And what we see is that from time to time, there are dislocations in the marketplace where the entire credit markets get repriced. Those are coincident with repricing of our stock.

So it’s like the moment you get a call from Filene’s Basement, we’re marking everything down 75%, it’s right at the same moment your credit card company calls you and says, by the way, we just cut off your credit line. So we want to be able to be there when the bargains service in connection with market dislocation, even if our ATM shuts down. And by the way, it doesn’t have to shut down. We just choose not to sell stock below NAV. I don’t believe we have for years now.

Is that helpful?

Jonathan Bock - Wells Fargo Securities

Yes, I appreciate it. It’s just a general question that lots of people ask, in a tighter spread environment, as it relates to essentially raising the equity book at a point when at least we would hear it’s rather difficult to originate quality credit. So no, I appreciate your candor in that regard.

John Barry

A couple of other things. The amount of stock that actually gets sold through this ATM is a very modest amount on a daily or almost daily basis. Every sale is accretive to the NAV. And we believe that we can make a profit off of each share that we sell. As well, this is an inducement to these credit providers to provide credit. So there are a number of other less immediately apparent reasons for keeping it in place.

But I would tell you that we do restrain the amount that is sold that way on any given day, week, month. So I think it’s now, at this point, fairly low. I don’t have the exact percentage of our equity capitalization that is augmented on a monthly basis that way. Brian, do you have it? It’s fairly modest nowadays.

Brian Oswald

We issued about $140 million to $150 million over the last quarter. Let me add some items to try to help answer the question. Year to date, in the calendar 2013 year, we started the year in an underlevered situation, because we wanted to make sure we had lots and lots of dry powder to meet origination requirements in the December quarter, given all the tax-driven activity, people calling up needing to close by 12/31, etc. Year to date we’ve issued at a pace of about 1.5x to 2x debt versus equity. So I think we’ve been prudent to walk up that leverage while still keeping it overall in the modest category.

And on a daily basis, the ATM has been in the range of 10-15% above book. We use that as a way to reward credit providers to our company, and that’s a major derisker, to have 18 banks in our credit facility. We more than any other BDC by a country mile. And this program helps to attract significant credit to our company, acting as an anchoring point when we hit the next recession.

I would also say that in current year 2012, we experienced significant growth. We about doubled our business. We do not expect to double our business every year, ad infinitum. Mathematically that becomes sort of impossible after a while, as the dollar sizes get larger and larger. And we do expect to continue to grow, but we expect the rate of growth to decline. And so the need for equity at the same level should decline as well. So I think these are all positive signals for equity investors.

On the point of the stock price, and kind of where we’re trading, there are a lot of different catalysts we can talk about for our business, monetizing existing controlled investments, rotating towards higher-yielding investments, new strategies that are ramping, like real estate, etc. But we think pure awareness generation and focusing on that and building that is maybe the most important catalyst of all. Because we’ve been so laser beam focused on performing and less on communicating on what we’re doing that we’re now playing catch up.

We just hired a head of investor relations, [unintelligible] Finn, who’s starting in the next couple of weeks. We’re doing a webinar this afternoon for new investors. This forum right now is more for people already familiar with our company, who want to know what the earnings are and ask detailed questions, but a lot of people who are new investors might have more basic questions. You know, what is a BDC?

There’s a lot of awareness to be generated about what is a BDC for an industry with a combined market capital of only $20-25 billion. We’re sort of where MLPs were 10 years ago. We’re going to more conferences, we’re doing more outreach. So we would argue that awareness generation is very good for existing and prospective investors who are looking for a catalyst any time they buy a stock.

Jonathan Bock - Wells Fargo Securities

With [APH], the amount of structuring fees that came in from APH this quarter, do you happen to have that number? I noticed it was $4 million for the year. What was it this quarter?

Grier Eliasek

Probably at least half, because we closed the Pembroke Pines deal, which is our largest multi-family investment, in the June quarter, which represents about half of our real estate book. So I would say probably about half in the June quarter.

Jonathan Bock - Wells Fargo Securities

And then one question that we’ve posed to a lot of CEOs as it relates to risk [unintelligible] today. Obviously a number of people talk about risk and as it has increased, in general, just in sponsored back lending, I understand that you have many multiple ways to skin a cat and earn a return, but wanted to turn to maybe a few of your specific transactions that you originated this past quarter.

And just wanted to take a look at one in particular. Arctic Glacier. So this would have been a deal that you provided subdebt financing at a 15% coupon, about 5x leverage through the subdebt. Today, HIG dividend recap is roughly half their equity investment. You step up your second lien senior position and the covenant light loan at L plus 1000 with a $1.25 floor, and leverage in excess of 6x.

So how would people choose to say that the all-in return is lower, leverage is likely higher, and the sponsor’s taking money off the table? How do you view that in light of the fact that you’re getting a lower return, at what some people would say is that the risk in this loan has increased?

Grier Eliasek

And I remember you asking about Arctic when we closed that a year ago. Arctic is a company which the sponsors managed well of the past year. They’ve optimized operations, they’ve taken a lot of cost out of the system. They’re also looking at a pretty robust pipeline of add on acquisition opportunities.

You’re right, getting paid 15% sounds good at a high level, and a lower [unintelligible] point, but you missed a piece that we did trade into a secured position, which we were lacking before, in the mezzanine context. So we have a true…

Jonathan Bock - Wells Fargo Securities

I was always under the impression that loss rates on second lien senior collateral was generally the same as mezzanine just per Moody’s reports. So are you saying the second lien position could provide….

Grier Eliasek

I think that needs to be dissected. And I’m glad you asked this, because there’s a lot of confusion when people look at deals and how they’re announced in BDC books. For example, sometimes people report it first lien, but it’s really a last out first lien that we would classify as a similar credit profile to a true second lien that’s a senior second lien without a subordination.

So we do not have payment subordination this deal. That means the first lien cannot block us. And that’s a major derisker, as opposed to the prior situation where you had a payment block possibility if there’s a downturn.

So I think on the scale, there’s some positives, some negatives overall. The bottom line is we evaluate each such deal as a brand new credit, a brand new situation. And if we’re not comfortable, we’ll take the payout, which of course happened to the tune of about $322 million in the past quarter.

Jonathan Bock - Wells Fargo Securities

And last question, as it relates to the CLOs, looking at the recent deals that you’ve done, what is the weighted average spread in general that you are kind of modeling those deals towards, or the weighted average coupon that you’re modeling those deals towards today?

Grier Eliasek

We model out in the range of a low to mid teens IRR. That [has been modeled], underwritten deals across 13-14% IRR range. But we use very conservative assumptions. We use default rates well in excess of what the market is experiencing. We model in recovery rates well below reinvestment spreads declining where they are today. Our base case, if you will, is what others would say is a downside case, in some cases extreme downside case, but we’re happy to do that. And then what happens is reality comes in much better than what we model out and so we end up with the higher return.

And this book has seasoned. We’re entering our third year now on [unintelligible] business, and we already have deals coming up which are, the call period is expiring, and we’re looking at calling deals and booking a substantial gain, substantial IRR, well above what we modeled out, or just straight out refinancing the AAAs, which are perhaps lower in certain deals in the current environment than the existing pricing of the AAAs.

Jonathan Bock - Wells Fargo Securities

Maybe I’ll rephrase it. What is your expectation on the collateral pool of the [unintelligible] deal as well as CISC deal today? What are you estimating in terms of the weighted average coupon on the BSL loans in the book?

Grier Eliasek

I’d have to go back. Off the top of my head, I don’t remember that particular deal, but we’re modeling out reinvestment spreads that decline in the range of [debt plus 350]. And basically the way we look at it is you’ve got a reinvestment period of four years. Typically the liability stack has a two-year noncall attached to it. And when you think about it, when spreads are declining, that is a signal of a positive economic activity in which default rates are more benign. We model out increasing default rates and declining spreads, which typically are not going to go hand in hand.

But those are the two risks you worry about, things being too bad, i.e. defaults and losses, or things being too good, i.e. declining spreads. Right now there’s a little bit more risk on things being too good in a declining spread, and that’s why we have been insistent upon controlling the call.

A lot of players in this market are smaller vehicles, they can’t write $30-50 million checks on deals like we can. Other BDCs have very small 30% baskets to manage these types of assets. They can’t write the larger checks, we can. So by controlling the call, we can optimize the exit. When things get too good, the decline in spreads, that’s fine, we’ll just refinance the AAAs, or just call the entire deal outright. And that’s what we’re evaluating on some of our more seasoned deals.

Jonathan Bock - Wells Fargo Securities

And with the tightening spreads in general, these are the last two, one, are you modeling in LIBOR floors as part of your assumptions? And then two, BSO collateral obviously is highly competitive in a rather frothy lending market today, which is essentially what the CMOs are buying.

And more importantly, beyond that, I think covenant light buckets within these securities could be between 40-60% of the entire portfolio. So how are you kind of judging risk as it relates to the fact that we’re relatively peaked in terms of spreads and getting tighter, and the fact that leverage is high and covenant light deals are extremely high relative to history and these two in particular have rather significant buckets with which to own covenant light loans?

Grier Eliasek

Obviously if we had our druthers we’d prefer loans to covenants, whether held directly on our own or through our collateral manager CLO book. But when we look at the risk profile, leverage stats, credit stats of today’s loans compared to seven years ago, in the 2006/2007 arena, today’s market still compares favorably.

And here’s the interesting thing about CLOs. It’s counterintuitive. You think about asset classes, you think about timing, you want to invest during a dip, you want to stay away during a rally. CLOs are much more about trying to print cheap AAAs than having option value for the future.

It surprises many to know that the highest returning CLOs were during the so-called credit bubble of ’06 and ’07. They think, gosh, that doesn’t make any sense to me. I would have thought these guys would have [unintelligible]. Nope, the exact opposite. Because you printed cheap AAAs, you had option value for many years into the future. And you could enjoy the benefits of volatility in that option value as markets went to a wider spread environment.

So we’re looking very carefully. The thing we watch very carefully is, when you’re ramping the CLO, we do all primary issuance. By the way, a lot of CLO equity is trading for some pretty hefty numbers on the secondary basis. We have steered clear from that. We like to underwrite collateral on a primary basis.

We reduce risk by having no CCCs. Zero. Completely clean baskets, when you start. We’re monitoring very carefully the mix between primary and secondary issuance. We don’t like paying a premium for loans that obviously have limited prepayment attached to them, whereas in a primary issuance you can get [unintelligible] through OAD of a point or two or sometimes three, depending upon market conditions.

So we obviously prefer that, all other things being equal. But then you’ve got to monitor the ramp, and you don’t want to have money laying around when you’re paying the liabilities and cash sitting around [unintelligible] leisurely pace. So all this goes down to a very very detailed set of models that our team runs.

At the end of the day, results are what matter, and we’ve been generating some pretty attractive results in the segment. CLOs, we didn’t put a lot of deals on the books in the latest quarter. More competition has come into the equity tranche, and if we’re not hitting commensurate returns relative to the risk profile we see, we say no. And that’s been happening quite a bit.

Does that mean that we’ll have a harder time growing CLOs in the future? Perhaps. We’ll see. I can tell you we are not lessening our quality standards one bit. And a big part of the quality standards is who we work with as collateral managers. We only have about a dozen collateral managers on our so-called approved list. That’s maybe 15% of the entire market.

Collateral management makes a huge difference. Huge difference in performance. And there’s some pretty big names managing a lot of AUM with some fairly mediocre track records that we say no to and are not on our approved list.

Operator

The next question is a follow up from Troy Ward of KBW. Please go ahead.

Troy Ward - KBW

In August you recapitalized CP Energy, $94 million. A press release was put out. And repaid, I’m assuming, your $18 million loan. A couple of questions. Are you now in control of CP from an equity standpoint? And will there be any large one-time structuring fees or other fee income generated from that buyout in the quarter?

Grier Eliasek

Yes, we have control, but this is, importantly, management are our co-investors in the deal, and have significant equity ownership. I think our fees are in line with typical fees charged in the 2-3% range on structuring fees. [We have] 1.5-3% of their typical up front structuring fee, and there’s nothing that’s out of that historical norm on this particular deal.

Troy Ward - KBW

So it would be the 3% on the $94 million?

Grier Eliasek

I don’t know off the top of my head, but it’s in the range of 2-3%.

Troy Ward - KBW

And then a follow up on Robert’s question from earlier, on the dividend fee income. If I look back over the past five, six quarters, and kind of back out the one-time income from Gas Solutions and other chunky payments that hit the dividend and other income lines, you’ve really been in the $12-17 million range. This quarter it’s almost $36 million, and the only pieces I’ve outlined in my notes are Wolf Energy accounting for about $5 million and the real estate property, [APH], accounted for a couple of million. That still leaves, call it, $27-28 million combined in those two lines. Can you let us know if that’s a run rate, or if there’s other big, chunky pieces in there that I’m just not accounting for at this point?

John Barry

While Brian tracks that down, I’m confused why people are suddenly backing out APH as nonrecurring. That is a highly recurring model with our private REIT.

Troy Ward - KBW

I wasn’t backing that out. I understand why that part, $2 million of it, is higher. Absolutely. I was just trying to whittle it down to the part I don’t know. I figure maybe $15 million previously was recurring, and now maybe an extra 2-2.5 from the real estate. But again there’s still probably a $10 million in there that I can’t account for, that I’m not sure is reoccurring.

Brian Oswald

I think you said dividend income at the beginning, but you really are talking about other income, right?

Troy Ward - KBW

Yeah, it’s actually both.

John Barry

Dividend income was only $14 million for the quarter.

Troy Ward - KBW

And then 21 for other, so the combined was like 36. So it’s really a combination of those two line items. I’m still $10 million over what it feels like should be a recurring number.

Brian Oswald

The recurring comes substantially from structuring fees, and we generally get structuring fees on most of our new originations. So that’s where substantially all of the other income in that… I think you need to model in based on originations that we’re going to have, 1-2% on all of our originations.

John Barry

Well, Brian, one way to think about it is of the $21 million that Troy’s asking about, we had $800 million roughly of originations. If you have an average fee of 2%, you’ve got $16 million there. And therefore now, whittling this down, the missing piece is $5 million which may or may not be recurring? How far off base am I, saying that?

Brian Oswald

Well, the missing $5 million is from H&M.

Grier Eliasek

You’ve got your $21 million right there, Troy. $16ish from structuring and originations, and $5 million from H&M.

John Barry

Well, we want to thank everybody for coming on the call in the middle of August. Have a wonderful rest of the month, and we’ll see you three months from now. Thanks, all.

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