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Prospect Capital Corporation (NASDAQ:PSEC)

Q3 2014 Earnings Conference Call

May 6, 2014 11:00 AM ET

Executives

John Barry - Chairman and CEO

Brian Oswald - CFO and Chief Compliance Officer

Grier Eliasek - President and COO

Analysts

Terry Ma - Barclays Capital

Andrew Kerai - National Securities

Christopher Knowland - MLV and Company

Greg Mason - Keefe, Bruyette & Woods

Jon Bock - Wells Fargo Securities

Operator

Good morning and welcome to Prospect Capital Corporation’s Third Quarter Earnings Release and Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today’s presentation, there will an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Mr. John Barry, Chairman and CEO. Please go ahead.

John Barry

Thank you, Jessica. 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 forecast 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-Q and our corporate presentation filed previously and available on the Investor Relations tab on our Web site prospectstreet.com.

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

John Barry

Thank you, Brian. Because we have so many new investors interested in learning more about our Company, we invite such investors to review separate and recently recorded webinars as an introduction to Prospect. Investors can access such webinars through the Investor Relations tab on our Web site prospectstreet.com. During those events, we talk through our overview of corporate presentation that is also available on our Web site. In the same location on our Web site, investors can also access our archived analyst and investor day that we held on July 10th last year in New York. This is a five hour webinar that includes senior members of the Prospect team presenting our multiple origination strategies and in-depth case studies to educate investors old and new about Prospect’s business.

Now onto our financial results for the quarter just completed, our net investment income or NII in the March 2014 quarter was $98.5 million or $0.31 per weighted average share up 19% on a per share basis year-over-year. Our net investment income for the past nine months is $273.1 million or $0.95 per weighted average share.

Our net income for the March 2014 quarter was 82.1 million and our net income for the past nine months was $247.4 million. Net income was up 30% on a per share basis year-over-year in the March 2014 quarter and was up 21% on a per share basis year-over-year for the past nine months.

We just announced more shareholder distributions through December 2014 giving investors seven months of visibility on future dividends. The December 2014 dividend will be our 77th shareholder distribution and the 54th consecutive per share monthly increase. Our May 5th closing stock price of $10.81 represents a dividend yield of 12.3%.

Our net investment income has exceeded dividends demonstrating substantial dividend coverage for the cumulative history of the Company. For the June 2013 fiscal year our net investment income exceeded dividends by $53.4 million and $0.26 per share. We utilized four pennies of that excess in the past nine months.

Since our IPO 10 years ago through our December 2014 distribution, at the current share count, we will have paid out $13.26 per share to initial shareholders and $1.3 billion in cumulative distributions to all shareholders.

Our net asset value stood at $10.68 on March 31st down $0.05 from the prior quarter. We have delivered solid net investment income while keeping leverage prudent. Net of cash and equivalents, our debt-to-equity ratio was 67.9% in March, up from 55.7% in June. We have substantial liquidity to drive future earnings through prudent levels of matched book funding.

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 should interest rates rise. Thank you.

I will now turn the call over to Grier Eliasek.

Grier Eliasek

Thank you, John. Our business continues to grow at a solid and prudent pace. As of today we have now reached over 7 billion of assets and undrawn credit. Our team has increased to approximately 100 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 selecting 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 in a low single digit percentage of such opportunities.

Prospect’s 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 12.5% as of March 31.

We also hold equity positions in many transactions, they can act as yield enhancers or capital gains contributors as such positions generate distributions. While the market has experienced yield compression in the past year we’ve continued to prioritize first lien senior and secured debt with our originations to protect against downside risk while still achieving above market yields through credit selection discipline and a differentiated origination approach.

Originations in the March quarter were 1.34 billion a record total. Originations have come in at approximately 3.3 billion in the past 12 months. We also experienced 198 million of repayments in the March quarter as a validation of our capital preservation objective.

As of March 31, we were up to 138 portfolio companies demonstrating both an increase in diversity, as well as the migration toward 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 March quarter were 65% weighted toward the last two business days of the quarter resulting in only a partial quarter positive income benefit from such originations. We expect such originations to generate full quarter positive benefit in the current June quarter.

Our financial services, controlled investments and structured credit investments are performing well, with typical annualized cash yields ranging from 15% to 30%. To-date we’ve made multiple investments in the real estate arena with our private REITs, largely focused on multifamily, 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 platform acquisition of CP Energy in the September quarter and closed multiple follow-on acquisitions in the December quarter. In March, we closed the Harbortouch acquisition with the simultaneous financing of an add-on acquisition. And on Monday of this week we close the Arctic Energy acquisition. We currently have other one-stop acquisitions under LOI or near LOI at attractive multiples of cash flow with both double-digit yield generation and upside expectations.

In the March quarter we made three investments in non-controlled third-party sponsor-backed companies they brought our total investment in each company to more than 100 million, demonstrating the competitive differentiation of our scaled balance sheet to close one-stop financing opportunities.

With our initial $92.6 million investment in Echelon to finance a diversified airplane asset acquisition, we have now entered the aircraft leasing sector. Echelon focuses on acquiring aviation assets with attractive contractual cash flows, strong lessee credit attributes and stable residual value characteristics. The Echelon management team has decades of experience in the aircraft leasing industry and expects to generate double-digit yields through a focus on mid-life aircraft.

Over the past few months we have entered the peer-to-peer online direct lending industry with a focus on prime, near-prime and subprime consumer and small business borrowers. We expect to grow our investment, which stands at approximately 40 million today, across multiple origination platforms, including potentially our own future controlled origination and underwriting platforms.

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 differentiated call center initiative continues to drive proprietary deal flow for our business.

As a yield enhancement for our business, we have launched a Prospect senior loan strategic initiative, called PSEN in which we would collaborate with third-party investor capital that would acquire lower yielding loans from our balance sheet while we would retain fee-generating servicing responsibilities on behalf of such investor base.

Once we close PSEN, which we hope to achieve in the coming months, we expect PSEN to help us generate accretive income and to expand our ability to close scale one-stop investment opportunities with efficient pricing.

Our credit quality continues to be stable. Nonaccruals as a percentage of total assets continued at 0.3% in March 2014. We have booked 268.2 million across seven originations so far in the current June quarter. Net of 96.5 million of repayments our net investment amount so far this quarter is 171.7 million. Our advanced investment pipeline aggregates more than 500 million potential opportunity is boding well for the coming months.

I will now turn the call over to Brain.

Brian Oswald

Thanks, Grier. As John discussed, we’ve grown our business with prudent leverage, which we’d recently expanded through two scale unsecured term debt offerings to help drive our earnings.

Net of cash and equivalents, our debt-to-equity ratio stood at 67.9% in March, up from 55.7% in June 2013. We believe our prudent leverage, diversified access to matched book funding, substantial majority of unencumbered assets and weighting toward unsecured fixed rate debt demonstrate 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 are 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 March 2014, we held more than 4.8 billion of our assets as unencumbered assets. The remaining assets are pledged to Prospect Capital Funding LLC which has a double A rated $792.5 million revolver with 24 banks and with a $1 billion total size accordion feature at our option. The revolver is priced at LIBOR plus 275 basis points and revolves for three years followed by two years of amortization with interest distributions continuing to be allowed to us.

We started the June 2012 quarter with a $410 million revolver and 10 banks, so we are seeing significant lender interest as we’ve grown the revolver. Outside of our revolver and benefiting from our unencumbered assets, we have issued at Prospect Capital Corporation multiple types of investment grade unsecured debt, including convertible bonds, a baby bond, institutional bonds 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 triple B rating from S&P and have recently received the triple B+ rating from Kroll.

We've now taped the unsecured term debt market to extend our liability’s duration up to 30 years. We have no debt maturities until December 2015 with debt maturities extending through 2043. With so many banks and debt investors across so many debt tranches we’ve substantially reduced our counterparty risk over the years.

As of today, we have issued 6 tranches of convertible bonds with staggered maturities that aggregate approximately $1.25 billion have interest rate ranging from 4.75% to 6.25% and have conversion prices ranging from $11.23 to $12.61 per share. In the past, we have repurchased such bonds when we deemed such purchases to be attractive for us. We have issued $100 million of 6.95% baby bond due in 2022 which is traded on the New York Stock Exchange with the ticker PRY.

On March 15, 2013 we issued $250 million of 5.875% senior unsecured notes due March 2023. This was the first institutional bond issued in our sector in the last seven years. On April 7, 2014 we issued $300 million of 5% senior unsecured notes due July 2019. We currently have $789 million of program notes outstanding with staggered maturities between 2016 and 2043 and a weighted average interest rate of 5.38%.

During and since the March 2014 quarter, in addition to our revolver expansion and program notes issuance, we have issued equity at a premium to net asset value and therefore accretive. From January 1st through May 2nd, we sold approximately 37.3 million shares of our common stock in our ATM program and raised 440 million of gross proceeds.

We do not anticipate filing another at-the-market equity program for the remainder of the June 2014 quarter. We currently have no borrowings under our revolver. Assuming sufficient assets are pledged to the revolver and that we are in compliance with all our revolver terms and taking into account our cash balances on-hand, we have over 900 million of new facility-based investment capacity.

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

John Barry

Thank you Brian, we’re ready for questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. (Operator Instructions) The first question comes from Terry Ma with Barclays.

Terry Ma - Barclays Capital

Hi, thanks for taking my questions, so just looking at your Progrexion investment, it looks like it’s about 7% in your portfolio, can you just give us some color there on the risk reward and maybe just talk through the rationale of funding multiple dividend recaps from this company, it looks like it’s levered about 6 to 7 times all in?

Grier Eliasek

Sure, Progrexion is a company that performs terrifically well in our portfolio, this is a company that corrects errors in individual credit reports, that folks might be aware that the credit bureau reports tend to be rife with errors, identity issues, mistakes, et cetera. That can hamper FICO, they produces FICO scores erroneously and hampers access to credit for individuals, so this is a subscription-based service that provides tremendous value, which has been recognized with significant growth in the business, we have recapped the company multiple times against that growth run rate leverage I think is substantially lower than some of the numbers you have quoted and we’re pleased with the performance of that company.

John Barry

So this is John Barry, I would add that one of the things that we believe is happening in the United States is that people are more alert to their FICO scores, they’re more alert to their need to keep track of the availability of credit, the interest rates on their credit cards, erroneous reporting, getting their finances and alike and that this awareness is what drives the demand for this company’s services. We don’t see this pool of people wanting to be smarter about credit reporting and how they’re depicted when they get a loan or a credit card or a car loan as falling off, we see it as growing and given that Progrexion is either the leader or one of the leaders, I think it is the leader in that marketplace. We believe that the company has a strong future.

Another point I’d like to make here is that when we loan to a company and sit there with the loan for several years and it does well and we get to know the company and we participate as observers in the Board meetings and get to know the management and the team at the sponsor, in this case HIG. We developed a, I guess a level of information about the company, its ongoing operations, its prospects and its future that it’s hard to get if you’re coming with a fresh loan. As a result we find it making additional loans to companies where we know the situation is good risk reward for us.

Brian Oswald

I’d also add that it’s a granular business with thousands and thousands of customers, so we look at it as a diversified business.

Terry Ma - Barclays Capital

That’s good color thanks, can you maybe just give us some color on the credit trends you’re seeing in the installment loan space and the auto finance space, just given we’re coming off cyclical lows in net charge-offs and delinquencies?

John Barry

Sure, we’ve seen in last year in 2013 an increase in some of the charge-offs in the consumer subprime space, not a massive spike but an increase and that trend has actually reversed itself over the last several months and we’ve seen improvement in credit quality. In general one of the things we like about the installment space and as we’ve discussed before when we made our first investment in a junior debt instrument in a company that refinanced us many years ago, so this goes back seven years ago approximately. We did analysis on this industry going back all the way to 1980s through multiple credit cycles and recessions and we are quite pleased with the stability in that charge-offs and delinquencies don’t seem to go through super spikes in this market as they do in other markets, so when we talk about increases and decreases they tend to be more of the modest variety as opposed to the significantly volatile variety. So we’re seeing an improvement there when we’re talking about the installment space, auto finance, we own a company called the Nationwide and you’ve seen it really depends upon what each company is doing but we have got a very disciplined operating management team there that has not been chasing volume and has been very careful about credit quality, so there’s significant stability there as well.

Terry Ma - Barclays Capital

Yes that’s great and can you just talk about PSEN real quick, what kind of servicing fees are associated with this and how we think about that going forward?

Grier Eliasek

We don’t have a number yet, this is an initiative we’ve launched we’re in conversation with strategic investors for this, but we do expect there would be some accretive fee income from this, primarily it would be a capability enhancer that would allow third-party capital to come in and purchase lower yielding loans as part of a one stop proposition where we bifurcate. A one-stop solution for private equity firm or some other third-party owner into say in A and B PSEN, the A, advertising sweeping out first before B and so having a lower coupon and lower yield attached to the A than the B. So we would have another investor basically purchase the A and then prospects would retain the B on our balance sheet so this would allow us face the market from a sponsor and order perspective in a one-stop fashion, while offering efficient funding solutions to them and enabling us to rotate out of some of our lower yielding investments in our balance sheet into higher yielding ones. So the two pieces of accretion we would seek to achieve would be one through fee income and two by rotating into higher yielding position.

John Barry

Alan this is John Barry. We do need to emphasize we haven’t closed this yet. And we’re looking forward to closing it with someone, oh it’s Terry, I am sorry, Terry I just want to be clear that we have not closed this yet. We’re in discussions with people. We think it would be a significant advance for our business and we hope we can close it.

Terry Ma - Barclays Capital

Okay. Great. That’s it for me. Thanks a lot.

John Barry

Thanks, Terry.

Operator

Your next question comes from Andrew Kerai with National Securities Corporation.

Andrew Kerai - National Securities

Yes. Good morning and thank you for taking my questions. If I could just go back to PSEN for a second as well too, so is the idea here that you originate loans at sort of at the BDC level, you sort of take the fee income then you basically just sell-off those loans to basically PSEN. So you’re clipping the 2% or 3% origination fee and then basically just selling off the loans out to PSEN is that kind of the idea behind the incremental fee revenue that you guys were talking about?

Grier Eliasek

Andrew we haven’t -- thank you for your question. We haven’t finalized the structure with the investor base here, that’s one of the items of discussion on the upfront portion. So that part is unclear the ongoing servicing would be more clearer. And that would be incremental fee income from third-party capital that we obviously don’t have today. So that’s one piece of it. I think even more of the accretion will potentially come from being able to sell off those again lower yielding loans and then add more higher yielding ones and affect the B pieces of the next one-stop deal that comes along.

Andrew Kerai - National Securities

Right. No certainly thank you that is helpful color. And then if I could just ask as well kind of about the SEC assertion that you guys disclosed is kind of given that has received a significant amount of attention this morning, so was the idea here that basically if you look back and the GAAP earnings would be lower as a result of this restatement, right. Then the idea is that the incentive fees would also be lower, so just trying to understand from that perspective, given that the fees have already been paid out, would that imply that you would be affectively lowering part of your incentive fees in the future to kind of tamper that or how I guess, how should we think about that from simply just, I guess, just kind of a taxable income perspective?

Grier Eliasek

If that investment income was lower the calculation in the management agreement would require that the fees would be recovered.

Andrew Kerai - National Securities

Okay.

Grier Eliasek

So that would actually be an offset to any decreases in that investment income and it would also be an increase to taxable earnings and distribution. So from a shareholder standpoint there is little to know downside to a restatement if it is required by the SEC.

Andrew Kerai - National Securities

So I mean I guess that…

John Barry

The best disclosure is to look at Page 100 of our 10-Q where we outline that in detail.

Andrew Kerai - National Securities

Right, no, but I just wanted to, I guess be clear that so I guess NAV it’s historical taxable income would be increasing then I guess the two sides of that is one that benefits are now. And secondly that also increases the amount of, I guess distributable net -- just the taxable income I guess, if that’s -- if I am reading that correctly?

Grier Eliasek

Yes.

Andrew Kerai - National Securities

Great.

John Barry

Taxable income, net income, NAV would all increase on a historical basis and we believe that net investment income would become much less useful of a metric for our taxable earnings and distribution requirements. And as we’ve said in our release, we probably would need to show that sometime we have adjusted NII to clarify things for investors which would also be expected to go up through the incentive fee reduction.

Andrew Kerai - National Securities

And have you done an analysis, I guess based on if this were to take place, if you sort of had to apply this guidance historically, what would your sort of undistributed or spill-over income be at the end of Q1 compared to the roughly, I think it’s about $0.20 or so now?

Grier Eliasek

We are in the process of making that calculation now. We did not have that.

John Barry

It will be a higher number, but we don’t know how much higher.

Andrew Kerai - National Securities

Sure, sure. Got it. No certainly thank you. And then, also I just wanted to talk about the CLO investment cycle as well, and you guys obviously account for CLO investments on an effective yield method which can differ pretty considerably from sort of a cash-on-cash return from the CLO equity. If you were to look at the cash distributions from the CLO investments and kind of compare that to the income you recognize, do you guys have sort of the Delta and what that would, and what lift that would give to sort of that CLO, the interest income line?

John Barry

Sure. On a cash basis our CLOs are yielding in the about 22%. And on a GAAP basis we’re recognizing between 15% and 16%. So there is about 700 approximately basis points there, that we use to reduce our cost basis to provide cushion for the future. We are earning on a cash basis, while we are recognizing for GAAP income there.

Andrew Kerai - National Securities

Got it, so I mean, I guess if you were to take that in context then if you were to say, well your taxable or distributable NII when you look at the cash returns from the CLO equity would actually be higher than the dividend had if you would apply, what seems to be more than a couple of pennies just from simply the cash versus the GAAP treatment for CLO equity, if I’m interpreting that correctly?

John Barry

That’s correct. Tax matches pretty closely with CLOs cash, so if you’re only recognizing part of the cash as income to basically and in fact build an economic reserve against potential future losses. And you actually have higher taxable earnings when you do GAAP, that’s correct.

Andrew Kerai - National Securities

Great, thank you for taking my questions.

John Barry

Sure.

Grier Eliasek

Thank you, Andrew.

Operator

The next question comes from Christopher Knowland with MLV and Company.

Christopher Knowland - MLV and Company

Hi. Thank you for taking my questions. The dividend coverage deteriorated a little bit in the quarter relative to the last quarter, given the balance sheet debt leverage is pretty close to 0.7 debt-to-equity what’s the strategy here or the options in terms of trying to improve the dividend coverage, if any?

Grier Eliasek

Sure, thank you Chris. Recall that leverage stat is a balance sheet stat as of 3/31 and income of course covers the entire quarter. A lot of deals about two-thirds of our originations last quarter actually not closing the last two business days of the quarter, which is generally outside of our control, our sole control as to when these deals close. Sometimes they seem to get longed towards the end of a period because it becomes easier for a change in control and start a new reporting period at quarter-end or month-end. So our hope is that those deals would then be full quarter contributors in the coming quarter, so that’s one piece of it. Second piece is the PSEN initiative that we talked about earlier. We hope and anticipate, it could be an earnings driver as well again, through both incremental servicing as well as rotating some of the lower yielding, say 6% or 7% yielding assets on our balance sheet into double-digit yielding ones. And we haven’t calculated precisely what that impact would be. We’re still in discussions with strategic investors for that.

Christopher Knowland - MLV and Company

So because of the late closings in the quarter, it’s fair to say that the dividend coverage is likely to improve going forward?

Grier Eliasek

That’s certainly what we are targeting, Chris. And again we would also emphasize that we have banked excess earnings, taxable earnings in the past two years and that’s available for future dividends. So we have used -- I think we disclosed, we’re $0.26 banked from the last fiscal year and we used about $0.04 of that so far in the first nine months of this current fiscal year.

Christopher Knowland - MLV and Company

Great, and can you give us an update on mix financials please? And then I will go back in the queue.

Grier Eliasek

Sure. As we disclosed in our Q, we’ve encountered the regulatory delays for that transaction. We’re working with the regulator to try to get that approved. We can’t promise, if or it will be approved, or how long it would take. But we do anticipate a delay. We also would need to work with the target company and extend the current agreement that expires in mid-June and currently here since May 7th there is not enough time to get a transaction done by mid-June even if we did have regulatory approval. So our objective is to work with that company and seek to extend the time period to enable us to address the topics that we disclosed in our Q with the regulator and it is our hope and desire to close that transaction but we cannot promise that a transaction would in fact close or close quickly.

John Barry

Chris this is John Barry. I would very much like to close that transaction. We’ve been working on it. How many months?

Grier Eliasek

Two years.

John Barry

Two years. And we’ve gotten to know the company and we’ve gotten to know the management. We really like the management. We like the company. We like what they do. We think it fits well into what we do. And we think we can add value to the company. We think the people of the company can add value to prospect. So what it’s worth speaking for myself personally. I would very much like to be able to close that transaction and so I’m hopeful that we can work out on extension with the company and that we can get the permissions that we need and that we can go ahead and close this as soon as possible. So that’s hope reality is well, we need permissions and until we get them we just don’t know whether we can ever close or how long it would take, but it won’t be for a lack of my trying or my wanting or my hoping to close that.

Grier Eliasek

And while it is a transaction, Chris, we would like to close to put into context it’s about $200 million equity value transaction which compares to the 1.3 billion we put on the books last quarter. So we want to close it but our world won’t end if we don’t.

Christopher Knowland - MLV and Company

Great, thanks for the color.

Operator

The next question comes from Greg Mason with KBW.

Greg Mason - Keefe, Bruyette & Woods

Hi. Great, thanks for taking my questions. First I wanted to talk about, in the press release you’ve talked about through the ATM program post quarter end you’ve issued 7 million shares but you don’t plan on issuing anymore, I just want to make sure I’m reading that correctly and is that because of this SEC issue?

John Barry

Yes, we’re not issuing on our ATM for the balance of this quarter while we sort through these topics. I think for investors that have looked towards the growth of our Company and the issuance of equity perhaps will see that as good news.

Greg Mason - Keefe, Bruyette & Woods

And what about other registered securities you’ve raised a lot of capital through the program notes and other convertible bonds, are those still options to raise debt capital?

John Barry

Well, Greg, it’s John. These are options what to raise capital to the ATM redeem capital program. As you know from time-to-time we do more or less or zero under those programs depending on the demand in the marketplace for our capital depending on credit spreads depending on refinancing, depending on paybacks. We’re managing as I think everyone on this call knows a large incoming and outgoing capital book part of that management includes the availability of the option of the ATM and in capital. Neither of which on any given day or week or month are significantly substantial additions to our capital base. It’s nice to have those options but we feel it’s prudent while we are having discussions with regulator concerning our appeal that we suspend those programs just prudent. And hopefully we will have the option to employee all of the tools at our disposal at some time in the near future, but we’d rather be too conservative than not conservative enough.

Grier Eliasek

And as we’ve discussed and folks know we taped the term markets in a significant fashion in the past two months having pioneered the convert market for the industry, we priced our six convert over a month ago and having pioneered the institutional bond, straight institutional bond industry as well for BEC sector. We did our second such deal a month ago as well. So we raised a significant amount of liquidity that way. Our revolver is currently undrawn so we have a significant amount of liquidity there and we have over 4.8 billion of our assets which is approximately 80% are unencumbered. So there is potential things we can do on secured front as well I am not saying we would encumber all those assets right away but we do have a store house of value there that we can utilize for financing for our capital needs. We were at 0.6 to 0.8 debt-to-equity as of 3/31. And mostly folks are happy that we’ve boosted our debt to equity ratio, as people have been looking for us to do in some cases for years, but what we have to do is we have to manage the proper balance at our company we need to manage our proper balance on leverage or proper balance on liquidity.

We have other store houses of liquidity as well, if you look at the sub 10% yielding access, I think that’s, approximately 500 million give or take on our balance sheet there that’s another store house of liquidity that you can use to portfolio rotate. So we have a lots of liquidity right now, we don’t put our origination targets but I think, 1.3 billion we did in the March quarter that’s probably not something you’re going to see replicated quarter-after-quarter but we have lots of liquidity for future deals.

Greg Mason - Keefe, Bruyette & Woods

Yes. That’s great and with that ability to still draw on the credit facility now, what leverage level are you comfortable with taking the balance sheet to at least for a period of time where you can’t issue any equity with this SEC issue?

Grier Eliasek

I would say somewhere in the 0.75 range as we talked about in the past and leverage will move a little bit up and down around some type of a band, but we think since we pioneered so many of these longer dated liabilities in the industry, as really the first to open up these possibilities to the industry whether it’s converts or straight bonds or our program notes. It allows us to say we run a matched book funding from a tender standpoint. And that give us the confidence now for us to say 5, 10 years ago on the industry before we prospected pioneer at the term market to the industry. To run at that type of leverage level which we think still gives us as a quite a healthy cushion compared to the current one-to-one limit.

Greg Mason - Keefe, Bruyette & Woods

And do you have any thoughts on the timeline for this SEC dialogue and when this could be resolved? Is this a month timeframe or are we talking 6 to 12 months, I just don’t have a concept?

Grier Eliasek

We believe that the process will be about a month.

Greg Mason - Keefe, Bruyette & Woods

Okay. Great. And then…

John Barry

But we have emphasize we really don’t know, we don’t control these processes. So we can estimate, we can guess, we can hope, but we do not -- this is not something we control at all, we’re better able to talk about things within our control and things that are not within our control.

Greg Mason - Keefe, Bruyette & Woods

Okay. Great. And then, on the structuring on Arctic Energy that you closed post quarter end, do you have any sense of what the potential structuring fee impact could be for a positive benefit next quarter?

John Barry

Brian you don’t have? It’s probably in the 200 bp best level consistent with other deals. We don’t have the number at our finger tip so that would be consistent with our average restructuring fee on deals.

Greg Mason - Keefe, Bruyette & Woods

Yes. Okay, great. And then one last question.

John Barry

We only have 300 bps in our restructuring fees.

Greg Mason - Keefe, Bruyette & Woods

Perfect that’s great. And then one last thing just to make sure I am thinking of the math correctly. You talked about the spill-over, it was $0.26 last year you used $0.04 of it this year. In the press release you put the dollar basis in there, so if I take 53.4 million spill over and you have used 16.8 million of it, gives you 36.6 million left, if I take that over the current shares outstanding, I get like an $0.11 spill over currently, I just want to make sure I am thinking about that correctly as we are modeling going forward it’s on a to-date basis, it’s low like $0.11 is that and my thought process right there?

John Barry

Yes. The answer is that, probably at the June 30th quarter we or year-end, we will have an update to what those numbers are, as we discussed earlier, the CLO affect what is additional taxable income from that is significant which it’s probably double to the number that you just discussed. So I feel confident that we’re closer to that $0.22 that we discussed earlier.

Greg Mason - Keefe, Bruyette & Woods

Great color. Thank you.

John Barry

Okay. Thanks Greg.

Operator

The next question comes from John Bock of Wells Fargo.

Jon Bock - Wells Fargo Securities

Hi, good afternoon, and thank you taking my questions. John, just to go back real quick as it relates to the SEC restatement topic for a moment and this is just to enhance my understanding. Because I believe you put in your Q an expected affect, if there was a restatement, if that was to occur. And I think point three, I mentioned that your historical NII will decrease by the amount of interest in structure income paid by those wholly own subs in access of the amount of income that can be reported as dividend income based on taxable earnings and profits now please correct me if I am wrong but does that mean that you booked more income into NII or more income to you, than the actual amount of earnings and profits that were being generated by those individual businesses?

John Barry

Jon, the answer there is yes and that’s absolutely the case with almost every company we have whether it is wholly owned or it’s a straight debt investment, the answer is that these companies are paying their interest cost out of cash flow, cash flow is the determining factor as to whether they can make their payments or not, so these payments were all made out of cash flow. Now a lot of these companies are going to have significant amortization and depreciation which will change what their taxable income is as opposed to their cash flow and those are the differences that are creating the changes.

Grier Eliasek

Jon to add to that we actually looked at a number of deals, I think several dozen actually, of syndicated transactions that we’ve done in the past, so these are companies not only we don’t control but are more kind of widely known, the larger sponsor owned many lenders et cetera and we’ve seen in the vast bulk of those situations that tax earnings is far below the interest payments. That doesn’t mean that companies are unable to service the debt, just shows the significant decoupling between economic ability and what’s happening on a tax fronts. Obviously they’re many businesses that have non-cash deductions available to them which they want to avail themselves of for proper and prudent tax planning. So if you suddenly held those same companies to the standard of saying that you can’t recognize interest income beyond tax earnings. You’d see many-many lenders across those deals wake up and discover that instead of having interest income maybe I don’t have return to capital distributions.

That’s a very simple example of what we have going on here where if the debt had been placed at the outcome -- income recognition. If instead it’s placed at a hold curve then some of the interest suddenly becomes a return of capital distribution. No economic change whatsoever, no change from a tax standpoint, the change is entirely from a GAAP standpoint and that’s why we say if that’s how the accounting was done, must be done going forward. Net invested income NII which other companies sometimes call NOI will in our opinion be far less useful for analysts, for shareholders, for ourselves to assess the business, and we’ll have to come up with other metrics we think will be more useful that adjust GAAP.

Jon Bock - Wells Fargo Securities

Okay the only question as we follow a number of BDCs we followed you for a long time and this issue obviously doesn’t materialize with any of them and so are you saying it should in the future or are you doing things that are unique relative to your competition.

Grier Eliasek

Well I’m not sure it’s an accurate statement to say that no other BDCs do controlled investments including wholly owned investments, I think there are some out there elsewhere in the industry and we can’t speak for other companies but we’ll see what happens in the industry between the regulator and other companies.

Jon Bock - Wells Fargo Securities

Okay, fair enough...

Grier Eliasek

But we do have a differentiated business model which we think history has shown has outperformed by having more diversified business that allows to do controlled deals and to capture attractive returns and remember when we do control deals in many cases, not always in many cases, the only third-party debt against these companies is an ABL revolver, but I think that is the only third-party debt, in some cases that’s a trivial amount of debt, some cases it’s zero third-party debt. So that’s why I like to call many of these less leveraged buyouts because we’re putting our own debt against these companies and seeking to acquire them at attractive purchase multiple.

Jon Bock - Wells Fargo Securities

Fair enough, fair enough. I guess the one thing I also wanted to jump into and make sure I got it correct, because you mentioned that you yourself felt it prudent not to issue equity or securities at this time, and maybe as this gets worked out, maybe I’ll pose a different question, are you deemed effective by the SEC to issue such securities?

Grier Eliasek

We don’t know, no one said we’re not effective, we just decided the last week that we didn’t think it was a good idea. And I would be very surprised if the SEC doesn’t agree with that, but they haven’t called us and they haven’t called me, how about that maybe they’ve spoken to someone else. We feel Jon that when you have a disagreement with a regulator the prudent course is to just stop doing anything that could attract attention and create controversy. And so issuing securities, why there is this discussion just doesn’t seem prudent to us, I’d like to get back to something that I’d like to be sure is not lost in the discussion, I’m not an accountant but I do feel I know a little bit about the leverage buyout business, having lived in that business for a few years.

In my experience leverage buyout firms, not just us other leverage buyout firms, typically buy companies using a holding company structure. Why is that? Well because there is sureties at the out OpCo. There are counter parties at the OpCo. There is a desire for a less leveraged situation at the OpCo on behalf of management. It’s very common for a leverage buyout firm to buy a company and put the equity in a HoldCo and then put it down as equity into the OpCo. So, we have done that. Now we understand, how do we simply not use a HoldCo but it use -- this is my understanding. Had we not used the HoldCo, but had simply put all the debt at the operating company -- my understanding is that there would not be an issue. So, in other words, because we used the holding company there is an issue that would not exist without a holding company.

The economics of the transaction are exactly the same. From what I can tell, the cash flow generating power of the business to our company is exactly the same from what I can tell. But apparently if you make the mistake of using a holding company as so many of our competitors do, not necessarily publicly traded, and we haven’t done the analysis of publicly trading people. There’s a difference. And so we understand that. That that’s a viewpoint that some people may have, I can tell you that going forward in the future, we now know and we have to put the debt that we did it in these buyouts, we have to put it at the operating company.

Jon Bock - Wells Fargo Securities

That would make sense John, because the only reason that when you mentioned the use of HoldCo’s, like for example it’s a large bulge bracket P firms to purchase somebody, it makes total sense to have the HoldCo then own the OpCo because of protections and sureties et cetera. But the major difference here is, when they raise capital they often will bring third-party debt as part of that HoldCo. You provide both the equity and the debt yourself. So if it was all equity funds, superior amounts of debt with equity -- I guess that’s the major difference I see relative to the number of HoldCo’s that purchase operating companies in the future. So it does sound like there will be a change and I appreciate your candor in discussing all this.

John Barry

Well, I think it depends what I was saying so we’ve been using a method that’s common in the energy industry, common in the -- well rather let’s just start with the larger picture. You loan money to a cable company, they are not paying you interest out of earnings on profits. You loan money to a real estate company, they’re not paying you interest out of earnings and profits. You loan money to any capital intensive business, there are typically not paying interest out of earnings and profits. Number two, if you look at leverage buyout debt across the country extended by all kinds of financial access to leverage buyouts. I would be surprised if there is very many that anyone can find where the total interest is supported by earnings and profits in fact tax earnings and profits.

In fact, I’m going to make a huge confession here on this call. I never even heard of the concept of tax earnings and profits until about a year ago. So this was all brand new to me because I think people in the leverage buyout business are focused on cash flow. That’s the whole genesis of the industry, cash flow. What is the cash flow generating ability of the company? To pay its obligations, that’s what we’ve always focused on. By the way I would like to point out that I think that’s one of the reasons that are non-accrual rate as well. We focus very hard on that. Now we understand that when we loan into these industries, or do buyout some of these industries, we need to be extra careful, for reasons that were not apparent to us in the past.

Number two, you will often see in the energy industry and in the buyout industry investors using structural subordination. What does that mean? That means that the ABL lender, says I see that there is other debt underneath me. I don’t want it in this company. I want it in a holding company, very common position of ABL lenders. If you would like to have ABL lenders in your buyouts, if you would like to have cheap debt, that drives good returns for your shareholders, putting your debt into the operating company which other buyout firms do not do, will not enhance your ability to drive good terms with sureties ABL lenders, revolving credit, counter-parties, done in broad street it is a long list. But we now recognize that what we have done historically, we may not be able to do in the future, as far as where we put the debt. We don’t see it making any change in the cash flow generating ability of the companies that we invest in.

Jon Bock - Wells Fargo Securities

Okay that makes sense. Then I guess if we’re going to turn to Harbortouch for a moment, and we are talking about lending out of cash flow, there we see that that hundred some odd million dollar loan was an L plus A with 2% floor plus 6% pick. So would you assume that I mean the question is as if it is coming on a lot of cash flow, why add the pick component which is non-cash but then still flows into income?

John Barry

The management team likes to see a pick component there just so they feel like if there’s ever a soft month or a soft quarter or a seasonality piece, there’s a cushion there. We are careful users who pick and we know that if a company doesn’t pay every last penny back a pick down the road you get the privilege of reserving in full. And that pick interest is actually paid in cash, it’s not like these other pick deals we have some maize grinder that does 12 plus 2, and the two of you know one thing, it’s never going to be paid in cash and you’re hoping to wait till the end, so you’re a business of flexibility, if is not paid in cash then you do it through reverse it at the end. Ours is paid in cash for our control deals so we don’t, we don’t have an issue there, the potential reversal.

Jon Bock - Wells Fargo Securities

Okay, great thank you so much.

John Barry

And Jon I’d like to add, I’d like to take this, John Barry again, I’d like to take this moment to point out as well that anyone looking at the companies that we buy, I think could observe that we pay low multiples and that’s our discipline, that’s what helped us manage our company here, paying low multiples means that the company is better able to generate the cash flow to service all of its obligations, now some of the people we compete with, pay higher multiples, make loans that companies can’t service out of cash flow, and these people use pick. If you look at our portfolio, I haven’t compared us to every other company but I believe that our use of so called paying time securities where we merely accrue money that we’re not getting is very low, and it’s not that we couldn’t have done that. It’s not that we weren’t offered opportunities, it’s not that there weren’t companies to go buy, where we could have bridged the gap from cash flow to some future hope through a pick. We have declined two dozen such companies.

We’ve said if a company can’t generate cash flow to service its obligations on a current basis then that type of an investment is of way less interest to us. Now this Harbortouch thing is an unusual situation where we’re in fact joint owners with the management team that specifically requested that. We’d like to be a good partner with Jared there who’s a wonderful person by the way. Elsewhere in our portfolio look around, you will not see paying kind which is little bit I say, if somebody wanted to be recognized the income where it’s a question whether it’s there. You would think that that would be a place to look right, well we don’t do that.

Grier Eliasek

And Jon also, I’ve seen some folks write from time-and-time, oh that controlled book that must make prospects so much riskier than a straight debt book, and we look at it from an attachment point standpoint. You’re seeing leverage creeping up there across the board you’re seeing spreads compress in the mark middle market, it’s actually a little bit worse than a middle market right now than the last month and a half, than in the properly syndicated market where spreads actually have come back a bit because of outflows on the open end side. Whereas in the middle market like you have to keep getting invested there. Would you rather buy a company for 5.5 times cash flow or lend money to a company for 5.5 times cash flow, as an example, which is riskier to do?

It’s the same company, well obviously it’s riskier to lend money at 5.5 than to own the whole company at 5.5 and you have the upside to boot from being the owner there. So that’s what our disciplined strategy has been on the control side not to chase multiples into the stratosphere but to focus on buying companies that can generate cash flow as John emphasized before, that then it goes out to our shareholders to make distributions. So I think it’s very important to set that in context, controlled companies are not the majority of our company they can’t be under our regulatory and tax structure, they’re a minority of our companies but an important differentiated contributor that we think has higher barriers to entry than many aspects of this trade lending business.

You know in the sponsor business right now, if you go to a lender meeting to especially a smaller sponsor deal a company with say 5 million to 15 million EBITDA which the vast bulk of our peers focused on financing on the long tail, smaller end of our industry, you might see 20 seats around the table filled with lenders all bidding aggressively against one another in an eBay like fashion driving down threat, each offering little more leverage, we are uninterested in that game and you’ve seen us emphasize some of our larger transactions last quarter where we have scaled where there’s more differentiation available by writing a larger check size, there’re just fewer lenders that can do that, so we like to be in businesses like any business organization where we detect higher barriers to entry, where we can differentiate ourselves. We don’t like to be commoditized and there are folks that are allowing themselves to be commoditized because they are monoclines, all they do is sponsor finance, all they do is the smaller deals, and that lender doesn’t close there’re 10 folks that can replace him.

John Barry

You know, I’m thinking back to the beginnings of the leverage buyout business and it got started in part because standard accounting conventions would present a picture of a company that wasn’t generating a ton of cash, because there’s a lot of depreciation for example, or amortization of intangibles. So there was no buyout business until the early 80s when people said, wait a minute, wait a minute, the coin of the realm is cash, is cash flow and so look at this cable company, look at this real estate company, look at this Snapple company, look at this and that company, they have huge cash flows that enable them to service huge amounts of debt and other obligations.

So in our business that’s what we’ve always measured -- cash flow. In fact our terms are CADS, what does CADS stand for? -- Cash Available for Debt Service. What is another one? -- Cash Available for Distribution to Owner. That’s what we measure, that’s the economic value of what we buy, if we buy something that has lot of net income, whether you see these companies, they have a huge net income, but they’re eating cash, we don’t want to own those companies, maybe they look great to someone else but what we know is investing in a company like that means we’re going to be writing checks. So we’d rather invest in a company with no net income that is generating a ton of cash, because we believe that have been hired to produce cash flow for our investors.

Jon Bock - Wells Fargo Securities

Thank you very much for that long and very diligent response, thank you.

John Barry

Thank you, Jon.

Operator

This now concludes our question-and-answer session. I would like to turn the conference back over to John Barry for any closing remarks.

John Barry

Okay, well I’d like to wish everyone a wonderful spring day and a nice lunch. Thank you very much.

Grier Eliasek

Thank you.

Operator

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

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