This morning I had the opportunity to speak with Grier Eliasek, President and COO of Prospect Capital (PSEC). Mr. Eliasek is responsible for spearheading the company's diverse deal origination efforts. I am somewhat familiar with BDCs and was immediately drawn to Prospect's dividend, which currently represents about a 12% yield. It's nearly covered on current earnings and with added earnings in the future expected from a higher, more reasonable leverage ratio, I'd consider it to be secure, a rarity in this market where yield has become so coveted that it's extremely difficult to find a high yield that is secure and genuine. For that reason I was glad to have a chance to speak with him and attain a better understanding of the business, for both myself and the SA community.
BG: BDC Closed-end funds are an interesting structure. I've looked at a few, specifically Keating Capital (KIPO) lately, and come to some conclusions. One is that the BDC model doesn't really work without scale. Unless the enterprise is rather large, the management fees and expenses are so overwhelming that it becomes, statistically, extremely difficult for market outperformance or even respectable performance on an after-fee basis. This underperformance causes the stock to trade under NAV per share, which makes it difficult and unattractive for the firm to expand through equity offerings. One of the things I really like about Prospect is the scale. You're the second largest BDC and are run much more efficiently. As a result of that, your stock typically trades at or above book, giving you much more options than other BDCs. Would you say that this is one of the driving factors in the firm's success?
GE: Scale is indeed important, and we win a significant amount of business because we can hold larger transaction sizes. For example, last month we closed a $260 million financing for Broder, the largest T shirt distributor in North America. Very few players in our industry can hold such large deal sizes, making in many cases the upper end of the middle market less competitive than for smaller deals, where many lenders can hold smaller check sizes. In addition, our scale allows us to pursue more controlled buyouts, which tend to be larger transactions because we are purchasing the entire enterprise. Our scale also allows us to pursue the only multi-line strategy in the BDC industry, which includes sponsor finance, direct lending, operating buyouts, financial buyouts, structured credit, real estate, and other nascent areas. Because we have approximately 100 professionals, making us the largest middle market team in the industry, we can source more transaction opportunities than others (4,000+ deals per annum at last count) and work on many more deals given our sizeable bandwidth. And our stock is highly liquid with more than $30 million of stock traded per day. Our size also helps to contribute to our investment grade rating, which allows us to enjoy diversified access to a number of attractively priced financing markets.
BG: To follow up, what other characteristics are there that set the firm apart or make the model successful? Selective, multi-channel originations seems to play a big role.
GE: We went public 10 years ago with less than $100 million of capital, so we've succeeded for many other reasons beyond scale as well. One reason is a careful credit culture. We're now going on more than 6 years without originating a deal in our book that has gone on non-accrual. Another reason is a culture of innovation and hard work. We're very proud of the long list of firsts we've achieved in the industry, including the first BDC acquisition, the first convertible bond, the first institutional bond, the first and only weekly bond program, the first tax-efficient financial buyout, the first ATM program, the first call center, and many other firsts. Rest assured our team is hard at work on future potential move-the-needle ideas that create value for our shareholders.
BG: What do you see as the unique advantages and disadvantages of the BDC structure in general? What is your long-term outlook for the industry?
GE: BDCs are non-bank corporations with a tax structure similar to mutual funds. As long as BDCs pay out at least 90% of income to investors in the form of dividends, BDCs avoid corporate taxation, which makes BDCs tax efficient stocks for investors to own. BDCs have a permanent capital structure like closed end funds, but BDCs over time have tended to trade much higher relative to book than closed end funds due to the high dividends paid by BDCs. Unlike banks, BDCs do not take deposits, so while BDCs are subject to 1 to 1 debt to equity restrictions BDCs do not have the same intense regulation as banks. New bank rules limit the amount of financing that banks can offer borrowers through cash flow term loans.
This means BDCs can offer attractive long-term financing solutions to private middle market companies, which has resulted in the BDC industry growing from a combined market capitalization of approximately $5 billion a decade ago to over $30 billion today. BDCs are taking share away from mezzanine funds and banks, and that growth is expected to continue.
Banks of course are not going away and serve a valuable role providing collateralized revolving credit facilities to borrowers, which BDCs generally do not provide because BDCs are not a retained earnings model. But banks and BDCs can lend side by side to the same borrowers meeting those differing term and revolver needs for a company.
BG: I'm curious to hear what you make of Gary Kain's strategy at American Capital Agency Corp. (AGNC) and American Capital Mortgage Investment (MTGE) of repurchasing shares of his own stock and that of competitors at substantial discounts, 20-30%, to book. His reasoning makes sense to me. The equity he is repurchasing consists of extremely liquid assets that he would be paying full price for with his firm's capital if he wasn't repurchasing and buying competitors, and yet he's taken a lot of criticism for the move. Any thoughts?
GE: We don't focus on agency bonds, so I can't comment on valuations in that sector, but in theory the strategy makes sense to me as a value investor. It's a "double discount" strategy. First one looks at the underlying assets and believes such assets are attractively valued based on fundamental analysis. Then one looks at the stock holding such assets and sees such stock is trading below net asset value. Didn't Warren Buffett used to buy pooled vehicles at a discount in the same way through Berkshire back in the 1960s? In 2009 we made the first BDC acquisition in history by purchasing Patriot Capital at about 50 cents on the dollar. We've since reaped more than 40% unlevered cash realized IRRs from the deal. We would happily do a deal like that again. Most of our industry is trading above book at the present time.
BG: On the Q2 call, Andrew Kerai of National Securities brought up the idea of increasing leverage to 70% from the 48% you're at now, mostly through the revolver you have to both decrease the firm's cost of capital and also get NI above the dividend again. He estimated the net impact could be 8-10 cents per share in additional NI annually. Going through the math, it looks like he may have been a little conservative. I could see it adding 15 cents. It's good to hear that you and your team want to get there - you made that pretty clear in the call - but could you go through what didn't make it possible in Q1 and Q2? You're debt/equity went from 55.7% to 53.7% and now it's at 48%. Has the issue been a lack of worthwhile investments or is there something else?
GE: We agree we've been underleveraged for many years now, which is a reflection of our conservative nature. We saw the dangers of overleverage with many types of businesses and consumers in the last recession. We've been running around 50% debt to equity and would like to see that grow to closer to 75%. The speed of that movement might vary based on origination pace. We're seeing a lot of deal activity in the market right now, which we hope will bode well for originations, revolving facility usage, and term debt issuance.
BG: When does the growth slow and stabilize? The talk of 70% leverage, the additional term loan offerings, expansion into real estate, specialty finance, direct online lending, and so on all suggest the firm is still in aggressive growth mode. The gross asset base has expanded fivefold in 3 years and 47% in the last year. How large do you envision the enterprise being long term? Is there even a vision or is the plan to just keep expanding as long as you can raise funds and invest attractively?
GE: Our business grew rapidly in calendar year 2012, with the business approximately doubling due to activity driven by a surge in M&A and financings with the change in tax rates at the end of that year. Last year our growth slowed to a still healthy 30-40% growth based on similar net asset dollar growth but against a larger starting denominator base. Once the asset base gets larger, the rate of growth should slow down, which is a good thing from a percentage growth in share count basis as well. As a credit business, we don't think it is healthy to have growth targets. If we see zero good investments worth making, we'll make zero investments. Capital preservation is our first objective, followed by income second, and then capital gains third as icing on the cake. Growth is an output from finding attractive originations, not an input in the system.
BG: The firm seems to pride itself in the fact that senior management is significantly invested in the business and hasn't sold a share, with a combined stake of over $40mm, $1.5mm of which was added in 2013. Is there some agreement, formal or informal, against selling shares, or are you all voluntarily staying long? Why do you think the 'manager as an owner' dynamic is so successful most of time?
GE: We are voluntarily invested in our business because we believe in ourselves and our strategy. Our stock has been a wonderful investment that on a total return basis has outperformed the S&P 500, Dow, and multiple financial indices since we went public a decade ago. Over the past five years, the BDC index has delivered a 213% total return compared to 138% for investment grade bonds, 135% for high yield bonds, 128% for the S&P 500 index, 117% for equity REITs, 96% for leveraged loans, and 75% for the S&P 500 Financial index. No BDC has ever gone bankrupt or failed to repay its indebtedness. Long-term loss rates on BDC assets have averaged only 0.5% per year, compared to 2.5% for banks.
We believe strongly in aligning incentives through stock ownership. Our employees purchase stock in our company every year, creating the potential for "shared pain" as much as "shared pleasure" through such ownership. We subscribe to the time-proven "manager as owner" mentality in our portfolio, too. Managers in our portfolio are co-investors alongside our capital. For example, Franc Lee, the CEO of First Tower, one of our investments, purchased 20% of the company alongside our capital. When you're invested in something, you stare at the ceiling before falling asleep each night figuring out how to make the business perform better.
BG: A question about capital structure. I understand the desire to issue new shares when the stock is above NAV per share, in order to increase NAV per share, but at what point is the benefit outweighed by the high cost of equity relative to your other capital layers? How does the revolver fit into this? I'm just looking to get a better sense of how the firm thinks about capital structure.
GE: Our desire is to obtain greater market recognition of our track record and attractive valuation to cause the share price to increase and the trading dividend yield to decrease, thereby reducing our equity cost of capital. If our share price were to trade on a forward earnings multiple consistent with the peer group over the course of the next year, an investor would enjoy a more than 60% return from such multiple lift plus our approximately 12% dividend.
From a financing perspective, we examine on a daily basis our numerous accretive issuance options, which include our revolving facility, weekly program notes, convertible bonds, institutional bonds, baby bonds, secured funding, and other options. As discussed previously, our objective is to boost our leverage in a prudent fashion to drive accretive earnings growth.
BG: Among the other BDC CEFs, who do you think is doing the best job and who do you admire most? What sets them apart?
GE: We spend our time focusing on running our own company rather than flyspecking what others are doing, especially because over 90% of the BDC industry just focuses on more commoditized sponsor finance, which is just one of many lines of business at our company. We immodestly think we're doing the best job in the industry both preserving capital and driving returns, with our asset yield one of the highest in the industry because of our diversified origination approach.
BG: I, and I'm sure other investors, are thrilled to see that 91% of interest bearing assets are floating, many with floors, and 100% of liabilities - everything besides that undrawn revolver - is fixed. What is you and your team's expectations surrounding interest rates and the timing of an increase? What is the cost in terms of sacrificed rate for that floor that you negotiate with companies you lend money to?
GE: I think it was Keynes who said there are two kinds of people where interest rates are concerned - those who don't know where interest rates are going and those who don't know they don't know where interest rates are going. The Fed has given us decent visibility about the taper running off this year, and moving up the Fed Funds rate, which drives LIBOR as the floating component of our assets, is the next obvious move. We don't know if this will occur this year or next year, but it is an almost inevitable part of the economic cycle. We expect to benefit substantially from such increases because of our 91% floating rate assets and nearly entirely fixed rate liabilities. We don't typically need to sacrifice any of our return to have a floating component, and borrowers expect the floater in exchange for having the ability to prepay our loans with modest prepayment premiums. If borrowers insisted on pure fixed rate instruments, the non-call and prepayment protections would likely go up significantly, eroding borrower flexibility.
BG: From your answers above - not wanting to look at competitors, not setting growth targets, refusing to make deals based on some arbitrary predetermined leverage ratio - it seems like the focus is really put on the investments, investments, investments. It seems like you are focused on continuing to make great investments and believe that if you can do that, everything else will fall into place. Is that a correct assessment?
GE: (paraphrase) Mr. Eliasek thought that my assessment ignored the company's focus on the right side of the balance sheet - its routine looks at how to optimize cost of capital and extensive risk management controls. He talked about how much thought goes into financing activities, pointing out that the company's current revolver only encumbers about 20% of the company's assets as a product of the company's risk management focus. He agreed, however, that setting growth targets would be extremely detrimental to the company. He felt it would restrict the company from being as selective and free as it has been in the past few years. He again addressed the leverage ratio and gave me some interesting color, possibly the most important thing to come out of the interview. He said that the company regularly receives guidance from S&P regarding what needs to be done to maintain its investment grade credit rating. In the past, S&P has talked about .6x as a debt level at which S&P would become somewhat concerned and have to reevaluate the company, but recently moved that number up to .8x. Obviously there are a lot of moving parts that affect PSEC's credit risk, but that boost from S&P is meaningful and Mr. Eliasek agreed that it was a big deal part of why the company is now comfortable taking on more debt going forward.
BG: You talk about the multi-channel origination strategy as setting the company apart from its competitors. Some of it makes sense to me but some is difficult for an outsider like me to wrap my head around. Could you overview the various methods in which you originate deals?
GE: He first suggested I look at page 15 of the company's overview presentation which I've included below:
This is very important, when we talk about the left hand side of the balance sheet in our asset strategy and how we make money. 90+% of BDCs just do one thing, sponsor finance. This is lending money to private equity companies. It's an important part of our business, but it's actually a minority part of our business now. I believe it's about 45% now. It's a good business most of the time. There is spread compression going on right now. There's more capital, more competition. Yields are going down, leverage is going up, so we're a bit wary and we've actually slowed our originations in this segment and really universally. To find good deals you have to be very careful in the current environment. We win a lot of business there through our scale. Most BDCs are tiny; they have a market cap of a few hundred million dollars at best, and they just can't compete in the larger deals. We closed a $260M financing for example in January, and we can comfortably hold deal sizes of $75-300M that other folks just can't do. So there's actually more competition for smaller deals than larger deals, which is the inverse of how people sometimes think about this business, but when you contemplate capital availability, it makes sense. Players with more capital can close larger deals and benefit from that scale with less competition.
The second business is the direct origination channel, and what that means is we're loaning money to companies that are not owned by private equity firms. Family-owned businesses and the like. This is less of a repeat business than the sponsor channel. You have to go out and find your own deals. We have a call center with about a dozen professionals that make hundreds of outbound calls per week, drumming up deal flow that drives transaction opportunities in this channel. There's less competition because there are fewer people who are able to originate transactions here. So it drives deal flow both in the direct and buyout channels.
Buyouts are obviously where we take a controlling interest in the company. There's really two broad types of buyouts that we do. One is operating buyouts and the other is financial buyouts. Operating meaning the purchase of non-financial services companies. We've had very good success with our operating buyouts over the years. For example we bought and then sold several years later in energy a midstream pipeline gathering business called Gas Solutions. We made about 6x our money and just under 60% on our net investment. We bought and several years later sold an industrial business called NRG Manufacturing. That was an 8x return deal. We don't necessarily have to sell companies within any time frame. That's the benefit of having a permanent capital business, but we do sell them from time to time and that's another potential earnings catalyst for our company. Second type is financial buyouts where we have a huge tax advantage compared to other companies. So we can buy a financial services company that's housed in a c-corporation and pays taxes and then convert that corporation into a partnership that doesn't pay taxes. So we'll have a portfolio company as an end result that pays no taxes downstairs and we as a BDC pay no taxes upstairs which is very, very tax efficient, much like MLPs and REITs. We've purchased 3 financial services companies in the last couple years and we've forced, which is a take-private of a public company, Nicholas Financial, where we've already signed a purchase agreement in December and our hoping to close sometime in the early spring. So the percentages there- direct is about 10% or so of our business and buyout another 15%.
Structured Credit also known as CLO equity is another 15%. That's basically where we take senior secured loans and put them in securitization structures. That's levered about 10-1 and another aspect of financing accretively. That's an asset strategy that's yielding about 16% on GAAP basis and, going back to those financial buyouts, those are yielding about 20%, so we're getting very attractive yields out of that business. The CLO equity business - we take only controlling stakes, it's kind of a form of a buyout, and we're working with the leading collateral managers, generally the top 15% of the manager teams in the industry. That's again, about 15% of our assets.
The next segment is Real Estate. Currently about 5%, small but it's been growing. We have three private REITs in our portfolio and we've been purchasing garden-style multifamily apartments across the Southeast with good supply-demand dynamics and opportunities for new supply additions, attractive cap rates, generally in suburban markets of southeastern cities, and we're working again with strong management teams who have co-invested alongside us in those deals. That's a low double digit out-of-the-box yield but with possibility for rent growth and there's a lot of positive things happening in the apartment sector, namely that more people are staying in apartments for longer periods of time, and that's expected to continue.
The bottom right is syndicated debt investing which is more of an opportunistic business when things get backed up in the syndicated channel, we're one of the few liquidity bids, folks with capital available which is a big reason why we keep our powder dry and make sure we have plenty of availability on our revolver. If there's a capital shortage for others, then we've got it available to make money.
So that's a synopsis of our different origination strategies. Any questions on them?
BG: So these internal rate of returns are just a function of how competitive these origination strategies are? It looks like the buyouts and structured credit, you do much better in them and probably try and push them more than the other stuff. Is it because they're less competitive?
GE: There's higher barriers to entry. There's far fewer competitors, in fact I would struggle to come up with another financial actor who's able to do one-stop buyouts where we hold all of the term debt and the majority of the equity alongside management. There might be a third party revolving piece, but very few people have that capital available and we can be efficient. Time is money. It's not just so much about maximizing the purchase price for the seller if they're in a hurry, if they had a failed process because of something related to a buyer dynamic- people try the game of cutting the price last second, blows up the deal, blows up the auction, and we come in and say we're going to get this done efficiently and just one-on-one with the company. So we have big advantages there which drive returns. Our financial buyouts, as I mentioned, we have huge tax advantages as well. For CLOs it's partly a function of competition and partly of higher leverage in that business compared to the other strategies, but it's prudent leverage because it's non-recourse to the rest of our balance sheet and recourse to other deals as well.
BG: I've read a few articles on the company on Seeking Alpha just trying to gauge market sentiment and figure out what investors look at and think of the company as, and what I've noticed is that a lot of investors are thinking of PSEC more like a preferred stock than a common stock, an investment grade preferred stock yielding about 12%, and they feel that it's ideal to put in a tax-advantaged account and just hold it. Do you think that's a misconception or proper way to think of it?
GE: Well holding our stock in a tax-deferred account is a smart thing to do if you have that available to you. Straight preferred I think is overly-simplistic. I can understand why folks might think about it that way because they see the super-attractive dividend yield that we offer, but we have increased our dividends over time and we do have upside embedded in our business through equity as well. So we own equity in our buyouts, operating buyouts, financial buyouts. We control our structured credit CLOs and the real estate deals have been buyouts as well. So we have upside that shouldn't be forgotten about. We do have a number of controlled deals, and we may actually sell some this year. We'll see if we can get the right price. That's an additional catalyst that you would not have available to you as a preferred. If we were a preferred, there wouldn't be other levers like increasing our leverage prudently to drive more accretive earnings. So folks can think about us however they want to, but I think it leaves out some of the other benefits of our stock ownership.