Last week I had the pleasure to speak with Prospect Capital's (NASDAQ:PSEC) Co-Founder, President and COO Grier Eliasek, with whom I spent over an hour. In my questioning of him, my goal was to elicit a high-level overview of the company and get his take on many of the concerns that I feel Seeking Alpha readers and perhaps the entire investment community have with the company. Further, I tried to elicit some discussion that I felt would be helpful to investors that might be considering investment or may be contemplating increasing their exposure to Prospect.
After sharing some niceties and disclosing the fact that I was long PSEC, I asked Mr. Eliasek to briefly discuss the company, its multi-prong origination strategy, and how investors should differentiate Prospect from other BDCs in the market.
Grier Eliasek: Sure. It's a good place to start - looking at our asset origination strategy - because if you look at the universe of BDC's, I think there's about 42 BDCs that are out there but 90 plus percent of them look very similar to one another and are essentially monoline companies in one line of business which is lending money to businesses that are owned by private equity firms, and that's a good business most of the time. But what we really try to do at Prospect is to diversify our business and be a multiline player, be in more origination strategies and more parts of the middle market that allows us to be very disciplined and have a lot more choice to where we are going to be investing. And to be in certain strategies that have higher barriers to entry and have opportunities for higher return - and so we like that diversity.
Mr. Eliasek went through each of Prospect's origination strategies in detail with me. Following are pertinent highlights from that discussion:
1) Sponsor (Private Equity) Finance: Represents 45% or so historically of Prospect's business, but a bit less over the last six months, with more competition coming into that market. Prospect wins business there through scale, as competitors can't hold the larger deals. There is also significant repeat business in the sponsor arena.
2) Direct Lending: (10% of business) Lending money to companies not owned by private equity, i.e. family owned or other closely-helds. Less repeat business. Work hard to find them. High barriers to entry. Prospect's call center professionals make hundreds of calls looking for financing opportunities.
3/4) Operating/Finance Buyouts: (15% of business) Purchase controlling interest in a business through equity and/or debt alongside management.
- Non Financial companies: Past successes include Gas Solutions making 6X money and NRG Manufacturing 8X money. A nice equity upside plus current income stream.
- Financial buyouts: Tremendous tax efficient strategy. Buy financial companies housed in corporate structures, convert them into partnerships and make them tax efficient. Example would be First Tower in the consumer installment space. Significant yield opportunity. Nicholas Financial (NASDAQ:NICK), which Prospect is in the process of acquiring, would be the fourth such company owned in that space. That book of business yields in the 20-30% range with manageable leverage.
5) Structured Credit: (15% of business) a.k.a. CLO equity. One billion book. Broadly syndicated loans where Prospect buys controlling interest of the equity tranche of a securitization. Cash yields in the low 20s. Excellent history.
6) Real Estate: (5% of business and growing): Three private REITs housing multifamily deals - garden style apartments primarily in the Sunbelt states buying in the secondary markets.
7) Syndicated Debt: (% of current book not specified) Opportunistic strategy when liquidity is needed. More dormant than the other strategies at the moment.
I asked Mr. Eliasek if the Nicholas Financial deal was still set to close in April. He told me they were in the process of getting a proxy approved, moving it on to Nicholas shareholders for a vote sometime in the early Spring.
I then asked about the size of the business and whether he thought Prospect was becoming a difficult to maneuver aircraft carrier as opposed to a smaller speedboat.
Grier Eliasek: I don't think we are at risk being a GE or a Berkshire yet <chuckle> - I call that a high quality problem to have. Many of these businesses are still having significant growth ahead of them and scale is a big advantage. Not just to do larger sized deals but also to have bandwidth of opportunities. When you have 100 people that work at your company and new opportunities come in, we can always find ways to stretch the rubber band to make sure we have people to focus on the opportunities. Where the smaller shop with five or ten people just doesn't have the bandwidth - they get filled up on a couple of deals and no one has the time to work on it, whereas we do. For example at the end of 2012 remember how the tax rates were changing and there was a huge surge of M&A and financing opportunities and closings occurring. We closed something like 24 deals in the month of December 2012 alone, which was more than the number of business days. The only way you can do it is with bandwidth.
Mr. Eliasek stressed the optimization of the company's team. He mentioned the fact that Prospect has about a dozen in-house lawyers, a point I stopped him on and joked about with him. Following our lawyer banter, he went on to stress that he considers having them on staff a real competitive advantage and huge savings as opposed to seeing billable hours from a big firm.
Meanwhile, he moved on to discussion of the company's liability position, where he again stressed Prospect's investment grade advantage, flexibility, and banking relationships. Below is a birds eye view of the right side of the Prospect's balance sheet.
Our next topic concerned general competition for deals. I asked what Prospect is seeing on the low-check end.
Grier Eliasek: It's interesting ... we're seeing competition in a couple of different ways - one is in that sponsor segment that I started with - where it's a little bit easier market to get into - because the private equity firm controls the company and does the key diligence and the lender is invited in to compete with the lenders in a little bit of an eBay like auction. So there is more competition there and number two - the smaller check sizes to your point - actually have more lenders competing so if you are doing a 30 million dollar financing - a lot of the smaller BDC and other types of capital that can participate in those deals - and you might have 10 or 20 folks showing up providing terms and sometimes those can feel like race to the bottom events. Whereas if the $30 million becomes a $300 million financing, well I can probably count on one hand the number of people that have the capital to hold that type of deal and we're one of them ... We haven't abandoned smaller deals, we do them from time to time.
AA: So would you say it's fair to say you are on the hunt for more of your larger size Nicholas financial type deals or a deal such as the large Broder Brothers one you did recently?
Grier Eliasek: Well we have the ability to do the larger deal for sure and yes our recent deal with Broder Brothers is a good example of that - and we already have a well diversified company by name 130 portfolio companies so we can hold that size deal in one place. All being equal, bigger is better for credit - a larger private company will have more lines of business, deeper management bench, more products etc... We don't abandon doing smaller deals at all and it's a relative value analysis. We'll continue to close both, but smaller BDC shops can't address the larger sizes.
AA: One of my readers wants to know why Prospect seems to be moving into non traditional asset deals including Nicholas and ramping of real estate exposure, which seems like a vertical move for you.
Grier Eliasek: Sure ... I'll talk about Nicholas first. We have been in the auto finance business for awhile. We bought a company called Nationwide, no relation to the insurance company, and closed that about a little over a year ago. We probably spent two years leading up to that studying the industry, thinking about the best way to participate. We spent a lot of time analyzing and researching before we wrote our first check and this is a business which is tremendously tax efficient. When you take the big picture, you think taxes in many ways make the world go round especially in the business world. Look at certain asset classes like MLP and REITs. Some would say that MLPs - that every pipeline and storage mid stream asset in America will someday be owned by an MLP because that is the most tax efficient home for it. Then we move onto REITS - and say every piece of commercial real estate will someday be owned by a REIT because that's the most tax efficient home for it.
Well what we figured out is that specialty finance companies - of which Nicholas is an example - as an auto finance company, arguably, all of those will someday be owned by a BDC because - let's use First Tower as a good example. First Tower is a 80 million EBIDTA dollar business we bought two years ago - housed in a tax paying C corporate structure - and that's a size large enough to go public. The company could have gone public on its own. The problem is when you are a finance company and you go public, and you have to therefore be in a C-corp. structure, you really don't get very many tax shields under the tax code. You get interest as a shield from borrowing money in your bank lines, but that's about it. It's not like being a manufacturing company where the code gives you tons and tons of write offs, deductions and tax goodies. As we try to stimulate more manufacturing in our country - and as manufacturing decreases year after year - so what do you do? Well convert into a partnership and sell yourself to Prospect Capital. Because we make it more tax efficient, and that's an edge.
Discussing deal flow further, Mr. Eliasek stressed Prospect's thoughtful due diligence and why they do different types of deals with different types of companies (i.e. cyclical vs. non-cyclical).
Changing gears, I asked him to comment on a hot topic this past week, since it resulted in a general sell off of BDC shares. That being S&P's decision to eliminate BDCs from consideration in its index tracking products, removing Prospect from the S&P SmallCap 600 Index, of which it was a constituent.
Grier Eliasek: ... It's very simple what occurred here. The indices like S&P and other folks that publish these really kowtow to the ETFs ..... When the ETF reports to its investors what its cost structure looks like, the current SEC rules, which I believe are antiquated and misleading, requires an ETF, if such vehicles purchase a BDC, to add the cost structure of the BDC to their cost structure - so called acquired fund expenses - which makes the total expense ratio look much higher.... it's completely misleading.
Can you imagine if every time a mutual fund or index fund bought a stock, it had to add the cost structure to its cost structure? It's nonsensical. So what's happened is because of the annoying, frustrating, misleading SEC rule, which has been on the books since 1940, the ETFs constantly have a buzz in the ear of S&P saying please remove BDCs from the universe because it makes my cost structure go up one or two basis points - and these guys fight for a market share of one or two basis points. So finally there was enough buzz in the ear of S&P to cause them to change their methodology which is unfortunate because a lot of people believe in indexing - and they are certainly powerful principles behind that I won't dispute - but as BDCs grow in the economy and on the stock exchanges.... then the indexes start to look silly. The Russell indexes include BDCs, S&P does not. S&P claims to be reflective of the stock market - well how can it be a reflection if you've redlined, and no longer include an entire and important part of the stock market?
AA: So you think this comes down to ETFs being upset over a couple of basis points of stated expense?
Grier Eliasek: Oh yeah. And guess who has the powerful relationship? The ETF and indexes. They co-exist. So what's occurred is - and we were as surprised as everyone else - the news comes out and our stock gets pounded down 3% or so the next day ... it was annoying and frustrating but you control the things you can in life and risk manage the things you can't. It's kind of a one time event in the past. But it does create an opportunity for someone who wants to come in after, rather than before, such an event.
Certainly one of the big draws to Prospect Capital is its current 12% dividend yield. One of the things I've noticed reading other articles and perusing comment threads, is retail investor concerns over dividend sustainability. I pointed out to Mr. Eliasek that Prospect's recent operations measured by net investment income -NII- have not been total supportive of the dividend. I also pointed out that UNII has dropped a bit recently, giving some reason for pause. So I asked Mr. Eliasek to give us some color on what's going on operationally in the business, as there are many concerned about dividend sustainability.
Grier Eliasek: Sure. The bottom line for us is that we have out earned our dividend over the life of our company. We've been public for 10 years. We think that's a very strong track record. We did use some of our banked, spill back dividends the last couple of quarters and not a huge amount - we still have a significant amount of excess remaining. I think there's a number of earnings drivers and catalysts we are focused on as a company moving forward. One is business mix as it talks through the different strategies - pretty clear certain businesses are higher yielding than others and we've been emphasizing those - like our buyouts for example and structured credit.
I think the business mix should help on the yield and earnings driver front. The second catalyst is our leverage ratio. Many would say we have been significantly under leveraged vs. our peers. We've run at about .5, give or take, debt to equity for a while now. As a BDC you can currently go up to 1.0. There's legislation in Congress that could take this to 2.0, which is still much less than a bank that can run at 10. S&P has come out with saying they are comfortable with investment grade BDCs running at a .8.
So if we move a lot closer to that level over time that should be a nice accretive earnings driver for our business. The other thing I mentioned is while we do offer a very attractive yield of 12%, a nice entry point for a company, we're comfortable as a company and have declared forward dividends many months into the future - announcing dividends all the way out to September. So ours is a recurring cash flow of business with significant income that comes in on a repeatable basis through our loans. We have a decent read, which is helpful and we've also paid our dividend monthly which a lot of folks don't do and we've had positive feedback from our investors.
As interest rates and rate risk go up, which seems inevitable, when will short rates go up? We have positioned our business for that. All of our liabilities other than our revolver are fixed rate, and 91% of our assets are floating rate. So all things equal, as LIBOR increases, that's worth a significant amount in earnings. So we should benefit from that. A lot of folks are nervous holding bonds wondering what will happen as rates and inflation go up - a bunch of risk and nothing being paid on bonds compared to history. You can rotate from that into a BDC like Prospect and enjoy an attractive yield and interest rate. More people are starting to wake up to that. You can't wait for rates to up, by then you've waited too long. You need to position your portfolio ahead of that.
AA: Touching on leverage again, so short story is ramping up the leverage ratio from .5 to .75, or in that area, over the medium term, combined with ratcheting up deal flow would be a growth driver of the dividend going forward. Is that fair to say?
Grier Eliasek: That's fair to say and another catalyst beyond business mix and leverage ... one is we do have companies to potentially divest in the future, like my 6X/8X examples I mentioned. If we are able to get an attractive price, that is a nice driver. Another driver is we are spending a lot more time reaching out, communicating what we do, how we do it ... carefully explaining the moving parts of our business. We think that enhanced transparency can only help us going forward.
AA: NAV and market price have been flat for two years. Can you provide us with some color on how the portfolio is being managed for income generation versus NAV growth.
Grier Eliasek: Sure. NAV is up 50 cents a share over 3.5 years. What tends to happen when we buy companies on the control side, where you will see rise in NAV is off of equity upside of those deals. All of our assets are fair valued by an independent 3rd party on a quarterly basis. That's fine, that's an appropriate system. We are the first company in the industry to move towards that. But what tends to happen with that valuation process - is equity doesn't tend to move up too much, maybe a little, until we have sold the business and took the cash realization from the business. ... If someone calls us and says they want to buy a company in the portfolio, I see it's marked here, can we buy it for a dollar more ... the answer would be no. And so we think we're sowing the seeds to capture future value.
I'll give you another example with energy services, we have five offices across the country - and in energy we have a company called CP Well Testing, which is a business we were a lender to and then we acquired it from a small PE firm for a nice price. And we've been doing these add on deals where we purchase additional equipment, put it in the field and instantly earn money - make 50% plus - annualized return. I call them SmartMoney deals - if we can do that on the control side, we hope that can translate into NAV growth for the future. Also, we're hoping as we get our message out - as we feel we are an undiscovered gem -hopefully asset recognition takes off and our stock trades up - raising capital more accretively, that could be a NAV driver as well.
AA: Would you say then that market focus on the NAV with your difficult to value positions is somewhat of a mistake?
Grier Eliasek: Well, I would say if there is stickiness for a period of time, that does not necessarily reflect that there is some issue from what I can tell, so focusing more on the cash flow generation of the company - NII - more folks put more emphasis on that at least in the short- to medium-term.
AA: Why are some BDCs trading at a premium to NAV?
Grier Eliasek: Well ... can't speak to specifics of [others] businesses. If we can get our company to trade at the same forward earnings multiple as the peer group, let's say we can do that over the course of the next year, that snapback plus our nice 12% pay-to-wait yield would equal 60% annualized return. That's just math. I think we have a slide in one of our presentations that illustrates that. (see below)
The other thing is over a long period of time when you are making wise choices with your capital, opportunities come to you that can be significant and transformative. Go back to 2009 for example, when we were going through the dislocation in the economy, there was a smaller BDC called Patriot Capital that made some unwise choices. This ended up being a great opportunity for us because we had capital available. That was an $8 NAV business trading at $2 that we bought for $4, which was a good premium for that base and we reaped 40% unlevered IRRs and that book has been fully realized at this point from the investment. So you have an opportunity to do transformative things during dislocations and we're value driven guys hungry... not hungry for the economy fall apart.. .but ready to do well. There were so many other deals we wish we could have done, but didn't have the capital base to do ones back then. Now we have the capital to do something about it.
AA: So you are in a position with the floating rate deals to benefit in a rising rate environment, and have bank flexibility to capitalize on recessionary situations as well?
Grier Eliasek: That's right. Our revolver is a $750 million dollar facility.
AA: And that's not drawn on at all currently, right?
Grier Eliasek: Yeah, we draw on it very seldom. We'll probably draw on it a bit more, but we like to keep significant dry powder in that because when things seize up and no one anywhere can raise capital - and you've got it - you can do pretty amazing things with it. So, it also reflects a conservative mindset for liquidity. We as managers have more than $40 million invested in the company and have never sold a single share of stock. So we care about how the business is performing. So having a huge amount of liquidity on hand enables us to be prudent risk managers for the future.
AA: You obviously believe the company is well positioned for a feast or famine economic environment. But the belief amongst some is there is a lot of risk here - however one wants to quantify that risk - despite your impressive due diligence and fantastic record of - no non accruals on six years of origination. How do you respond to that belief, which is held by many? Would it be unwise of investors, such as myself, to live with rose colored glasses here - what happens if high-yield defaults rise precipitously again as they did five years ago?
Grier Eliasek: I think what occurs is we have a high dividend yield and you have a self-fulfilling perception that can creep in because you have a high-dividend yield - well, you must be risky. And that's kind of where things can settle out perception wise - which is why we like to see the stock go up and reduce that trading dividend yield and then maybe you get further momentum. And then you have - oh they just became less risky - even though the price went up, and the yield went down.
As a value investor, I usually think that's more risky... I want to buy a cheap price. I would encourage folks to look at forward earnings multiples and say wow - when you look at it from that basis, this is a very attractive stock. Income and value investors are often one and the same, so that's a good place to look.
How our business performs during the next recession - we have a strong credit platform where we thrived - we bought Patriot Capital, we continued to raise capital, our book did very well - we thrived - so this go around we have a stronger balance sheet. For the last recession we had one bank facility with one lender, now we have 22 banks in our facility in a non-recourse STV - and that's huge - it's so important.
Your usual BDC will have a bank facility, maybe a bond, and then equity. If you go through a recession, a problem, there's a breach of the bank documentation, a covenant breach, there's issues that emerge. Then the bond investors are next in line - maybe there's a cross default with them - and then you have to deal with them. In the meantime, equity holders sweat it out. Not the case with our business.
We are the only BDC that puts our secured borrowing into a special purpose vehicle, and we only pledge about 20% of our assets to that SPV. That means that 80% of our assets are on our balance sheet, unencumbered, not beholden to any bank or secured lender. And it's a huge credit enhancement for both bondholders as well as equity investors. So if there's an issue with the bank revolver, there are no cross defaults. You can't say that about other BDCs - they're going through covenant trips. It's a huge de-risker - it's not well understood - our balance sheet - at all.
Mr. Eliasek went on to talk about the company's industry diversification amongst 130 portfolio companies, illustrated below, which he sees as a huge de-risker as well.
I then asked him if he thought the market, to an extent, was incorrectly viewing Prospect as a junk bond company as opposed to an income and growth play.
Grier Eliasek: I think that's appropriate. They're just saying, you know the dividend yield is here and I just stop all analysis and think yeah, it's risky. You have to unpack the business, and look at the different pieces for how we produce our returns and when one does that, you see how well diversified it is, how it is at the end of a highly disciplined process, and how we're in markets that have real barriers to them. How we have to work our tail off to perform. So it's a much more robust story than just some type of junk bond. And we also have equity upside which bonds do not have. And we have floating rate assets, which bonds do not have.
AA: Grier, thank you for your time. Any final words for the Seeking Alpha audience before we conclude?
Grier Eliasek: I really appreciate all the time Adam. I would add that folks can go to our website prospectstreet.com - IR page, there's a lot of information ... presentations, introductory webinars, analyst/investor day we held last July - that's a multi-hour type of event - 20 people employed by the company talk about their lines of businesses and how we make them successful. We can also be contacted directly. Carlynn Finn, our head of Investor Relations or Brian Oswald our CFO are other resources available to answer questions.
You have to respect an executive that goes out of his way to get the word out on their company, especially when they feel the stock is being undervalued by the market. In the decade plus since Sarbanes/Oxley, I think many companies are afraid to talk more than they have to with the investment community for a variety of reasons. This is certainly not one of those companies.
I think it's hard to argue the fact that Prospect has transformed itself into a preeminent BDC with scale advantage, an innocuous, investment grade credit profile, and diversification on both origination and portfolio ends. But the market has been reluctant to trade the stock at a significant premium to NAV, and that might be considered surprising given the company's track record of no non-accruals on the books for six years worth of origination.
The dividend is mildly uncovered at present, but it appears a move to utilize additional leverage and a high IRR origination focus could reverse that trend during the course of this year. It seems the company has certainly been reluctant to invoke additional leverage, given its success at a current .5 debt/equity ratio. But with ATM capital raises not being highly accretive at the moment, it seems a prudent leverage ramp is a good option to keeping dividend growth alive heading into next year.
On the valuation front, I do tend to agree with Mr. Eliasek that Prospect's high dividends may be a self-fulfilling prophecy to an extent, despite the cheap comparative multiple illustrated in the chart. If the market should decide that it has overblown its risk assessment on PSEC, it could certainly provide for a very robust total return opportunity.
Given the flattish NAV we've seen from the company, it does appear that the market is resigned to viewing PSEC akin to some sort of elevated yield bond fund, which in the variety of ways Mr. Eliasek pointed out, it most certainly is not. The stock even tanked right away in response to the Fed's May 2013 taper announcement, which was a wonderful buy opportunity, given its irrationality. If anything, interest rate tightening and a more robust economic environment would seem to benefit Prospect's income statement and probably underlying asset values as well.
In any case, whatever general risks of investing alongside PE and in middle market companies one wants to conclude, I don't see any reason to necessarily fear an investment in PSEC. So like other PSEC shareholders, I am content to collect my 12 percent, and will consider adding more shares during brief dislocations, such as last week's S&P announcement. Could Prospect get hit on an NAV and income level in a recession or a random rise in high-yield defaults? Absolutely - nothing is bulletproof - but PSEC appears better positioned than most to deal with a downturn, and for now, to even take advantage of one.
Going forward, investors should be keeping an eye on the anticipated leverage implementation and whether it creates a symmetric upside effect on net income. One should also keep a peripheral view on non-accruals, especially if there's a general uptick in high-yield defaults, which have continued to stay low.
To conclude, I think the stock at $11, a mild premium to last stated NAV, and 12% yield, presents a decent risk/reward proposition for high-yield and total return investors alike. Though I think the market may still be reluctant to stray too far from stated NAV, I don't think a dollar or two of equity price upside would be far-fetched here if the market learns to appreciate the Prospect Capital story and management is able to edge the NII and NAV needles in a favorable direction in the coming quarters.
Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.