Prospect Capital (NASDAQ:PSEC) has to be one of the more underrated income stocks out there. The company is known for its large monthly dividends, currently yielding north of 12%, which is among the highest in the BDC sector and by itself offers an attractive total return.
A few days ago, I was provided with the opportunity to ask a few questions via email to Grier Eliasek, President and COO of Prospect Capital. As a shareholder, I really wanted to dig deeper into the "nuts and bolts" of Prospect Capital's operations, especially regarding originations, NII and the ATM share offering policy. As shown below, I really think Mr. Eliasek's answers provide great insights into the inner workings of the company.
Do note that some of the questions and the responses were lightly edited for clarity.
My first question on NII went directly to the point. While noting that this key metric had been trending lower on a per share basis in recent quarters, I asked what Prospect Capital was doing to increase NII on a per share basis. Furthermore, I asked how much of a "cushion" prior year excess NII provided the company?
Grier Eliasek: Recall, Prospect has significant "banked" net investment income from having underdistributed in the past. In the prior fiscal year we banked 26 cents of NII available for the future. Regarding future drivers of NII, we have several catalysts we are focused on. One catalyst is a prudent increase in our debt to equity ratio, which has historically been in the 0.50x range and which we can prudently increase to 0.75x while maintaining a cushion against our 1.00x regulatory limit. A second catalyst is a greater usage of our 30% basket for financial buyouts and structured credit investing, which tend to generate higher 15%-30% yields for our book on a stable, recurring basis. A third catalyst is a potential divestiture of lower yielding assets with a recycling into higher yielding assets. A fourth catalyst is the potential sale of one or more of our operating buyouts. We have had significant success with prior operating buyouts, including the sale of Gas Solutions for 6x our money and the sale of NRG for 8x our money.
In my next question, I asked about the competition Prospect Capital is seeing for originations. Specifically, I asked if its increased size had affected the day-to-day business operations of the company and if the new call center had added more opportunities. Furthermore, I asked if some deals were now too small to bother with.
Grier Eliasek: Our scale gives us enormous advantages. We have over $7 billion of capital and approximately 100 professionals, making us the largest dedicated middle market investment team on the planet. Because of that scale we originate over 4,000 opportunities per annum, which we believe to be more than any other group. Our scale team can work on selecting, structuring and closing from that origination set in a disciplined manner with a 2% book-to-look close ratio. We can close far larger transactions than other BDCs, giving us a competitive advantage in the marketplace. In 2014 we have already closed multiple transactions in excess of $250 million in size. Our call center, which we believe to be a unique approach in the industry, is a significant driver of originations for us, especially in the direct lending and controlled buyout arenas. Because of our scale we can close more controlled buyouts, which tend to be larger deals because we are buying an entire enterprise. We do see more competition at the smaller end of the market where $5 million to $20 million check sizes are required, but most of our originations have tended to be on the larger end with fewer competitors able to compete because of capital limitations, staffing limitations, expertise capability limitations, or some combination thereof. We don't tend to focus on deal sizes below $10 million except in limited situations.
In a similar vein to the previous question, I asked what Prospect Capital was doing to prevent loans from going on "non-accrual" status, specifically noting concerns regarding repeat borrowers and their ability to pay back their debt.
Grier Eliasek: With a 0.3% cumulative non-accrual rate, we have delivered sterling credit quality as part of our track record. In the structured credit business our default rate of 12bp was only 1/20th the market default rate of 240bp at the beginning of the year. Our systems and processes require approximately 20 blue ink signatures in order for a deal to get funded. Each deal must get reviewed by the deal team, a vertical subcommittee, the overall credit committee, a loyal opposition, our legal department, and our finance department. Banks continue to join our credit facility after extensive due diligence on our investment portfolio, systems, and processes.
Continuing on the origination front, I noted that Prospect Capital's "Sponsor financing" segment had over time become a smaller chunk of its portfolio. I asked if the company was looking to enter and diversify into other segments, such as real estate, and what was the target rate of return on these "non-core" investments.
Grier Eliasek: We do not pick hard and fast targets for the size and growth of any of our origination strategies or our overall portfolio. We find such additional constraints to be unhealthy "tops down" ones that distract from the disciplined, bottoms-up underwriting that has driven our success on a credit by credit basis. We are the only multi-line BDC (compared to other BDCs that solely do sponsor finance), which allows us to be disciplined because we have a far wider pool of opportunities from which to select. These include sponsor finance, direct lending, operating buyouts, financial buyouts, structured credit, syndicated lending, real estate, aircraft leasing and peer-to-peer lending. The latter three segments are more recent additions that we expect to grow in the future. Our focus continues to be on delivering a double digit asset yield, and our weighted average yield at the beginning of the year stood at 12.9%.
My next question was regarding the at-the-market "ATM" share offerings. I noted that Prospect Capital was aggressive in issuing stock via these offerings, with the share count increasing 60% last year. I asked how issuing stock compared to other financing options such as the recent convertible note offering. Furthermore, I inquired on how much of a premium to NAV the stock needing to trade for before it made sense to issue more equity.
Grier Eliasek: We view the ATM as a low-cost way of growing the balance sheet compared to discrete offerings. We only pay the sales agents, which are exclusively credit providers to attract more credit to our company, a fee of 50-100bp for such issuance. By comparison, discrete offerings cost other issuers 500-1000bp on average. We save shareholders a lot of money with this program. We also limit ATM issuance to a low percentage of daily trading volume. Recently we completed the issuance of both an institutional bond as well as a convertible bond, and we continue to issue our program bonds on a weekly basis. We have raised twice as much debt so far this year than equity, showing we are being prudent about our capital raising to minimize dilution to investors and to position ourselves to target enhanced earnings in the future.
My last question dealt with Prospect Capital and its approach to balancing risks and returns. With a yield of over 12%, the stock was priced assuming quite a fair deal of risk. Furthermore, Prospect Capital's share price struggles to reach a large premium to NAV, unlike nearly all BDCs. I asked, given the high yield on the common stock, does that make finding accretive opportunities more difficult. Furthermore, I asked if the high yield results in higher risk taking.
Grier Eliasek: Originations are a significant lifeblood of our business, and we focus hard on developing, sustaining and growing sourcing channels that generate attractive opportunities. We have closed over $3.3 billion of opportunities in the past 12 months and reviewed orders of magnitude greater than that in opportunities. Some of our strategies are higher yielding (like financial buyouts and structured credit) while some of our strategies are lower yielding in the sponsor segment. We like having a diversified portfolio to reduce our risk. We would like to see our trading dividend yield come down through share increases, which we hope to generate through greater awareness in the marketplace. Sometimes we feel like the best $3.5 billion market cap and 12% dividend yield company that no one has ever heard of. Perhaps you and your readers can educate others about our company.
Final Thoughts and Conclusion
As noted by Mr. Eliasek in his last response, Prospect Capital suffers from a lack of awareness in the market. Where else can income investors really find a 12% dividend yield trading at or around NAV?
Yes, NII has been trending lower. However, Prospect Capital still has tons of leverage which it can employ to juice returns. Note that some stocks with similar yields (namely mREITs) have leverage ratios well in excess of Prospect Capital's. Furthermore, the company has nearly a full quarter's worth of dividends in the "bank" for a rainy day and has declared dividends through September.
Prospect Capital's increased size has made it where it can compete for larger and larger loans, avoiding the "race to the bottom" seen in the lower end of the sector. Indeed, this focus on the "big fish" was put on display toward the end Q1 where the company closed on two $200 million plus sized transactions.
Furthermore, Prospect Capital's multifaceted approach to lending allows it to find good returns where it can and not be constrained following a fixed portfolio allocation.
One area where I do not necessarily agree with Mr. Eliasek is in regards to the ATM program. While equity offerings have slowed down in 2014, with the company raising twice as much via debt compared to equity, the cost of capital component (dividends) seems to be a bit much. Even so, the ATM program is not as bad as it could be given that issuing shares above the NAV is technically an accretive act.
I would like to sincerely thank Mr. Eliasek for his time and responses to my questions. It is not everyday one can converse with the COO of such a large and successful enterprise about such complicated matters.
Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.
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.