- Prospect's Case for External Management and Control Investments.
- Loan Originations, the Calling Center and Deal Flow.
- Troubled Assets, Debt Structure and the Dividend.
On Thursday, August 28, I had a one-hour telephone conversation with Grier Eliasek, President and Chief Operating Officer of Prospect Capital Corporation (NASDAQ:PSEC). The invitation to interview Eliasek for a Seeking Alpha article was extended on behalf of PSEC by Pam O'Brien, senior vice president of Pristine Advisers as part of PSEC's ongoing initiative to reach out to the investing community to make their story better known. Eliasek is a good listener. He is engaging, winsome and effective at communicating Prospect's message.
I am a former shareholder of PSEC. My wife holds shares of PSEC in her account. In a March 16, 2014 Seeking Alpha article, "The BDC Portion of My Portfolio", I responded to several articles about PSEC: Adam Aloisi's March 3 article, the Oxen Group's February 28 article, and Lawrence Zack Galler's article.
External or Internal Management
PSEC is one of the most intriguing companies I've studied. It stirs strong debate between loyal shareholders and critics. I have tried to remain objective and dispassionate. I accepted the invitation to interview Eliasek because significant concerns have been raised about PSEC's performance and the safety of its dividend. It is an honor to talk with a company COO and I'm always happy to learn more about a company, particularly one in which my wife or I have a stake.
PSEC is known for high yield, for rapid growth of assets under management, and for being avant garde among BDCs. In a comment following an October 11, 2013 article, BDC Buzz said "PSEC is about as renegade as I can handle ..."
In the March 16 article, I said my BDC investments would be limited to companies that are internally managed, in part because of BDC Buzz' two-part SA article in November, 2013 about BDCs with the lowest fees. So, I began the conversation by asking Eliasek several questions related to PSEC's external management:
What is PSEC's rationale for being externally managed? Specifically:
In his November 2013 two-part article, Seeking Alpha contributor BDC Buzz showed that internally managed BDCs tend to be less costly to shareholders.
Part of the external manager's compensation is a fee based on assets under management. PSEC has grown very rapidly, the number of shares outstanding has grown dramatically, with commensurate growth in assets under management. There is a built-in incentive for external managers to grow AUM. This is not automatically in the best interest of shareholders. Can you make the case that PSEC's rapid growth has been accretive to shareholders' net asset value or earnings?
Some investors believe the interests of shareholders and the interests of management are more in alignment if a BDC is internally managed. How do you address this shareholder concern?
Prospect's Case for External Management
As for the external manager and the shareholders interests being in alignment, Eliasek noted that the management team owns $50 million of PSEC stock and they regularly "buy on dips."
Eliasek's response was candid and straight-forward. He said, "We compete for talent with externally managed BDCs, with private equity firms and with hedge funds." He believes the best talent gravitates toward externally managed BDCs rather than internally managed BDCs. Though he did not mention compensation, my assumption is that externally managed BDCs tend to offer more favorable compensation. Eliasek's rationale for the relative attractiveness is that (in PSEC's case) "we do more than one thing" (more than just originating loans). "Many of (these talented people) wouldn't be here if it was internally managed."
Eliasek said their external management structure provides PSEC with greater skills (by recruiting the best talent) and with the ability to staff for increased sector diversity, resulting in 143 portfolio companies researched by staff specialists in various sectors, such as real estate (self-storage, student housing, and multi-family residential), online lending, aircraft leasing and oil field energy services. Eliasek said the diversification by industry is a major "sleep well at night" factor and their industry diversification is one reason PSEC has achieved an investment grade rating that he says is rare among BDCs. This has led to a lower cost of funding.
According to PSEC's recent FY 2014 earnings release, 25.3% of PSEC's assets are "Control Investments." PSEC has a controlling equity interest in these companies. Eliasek's description of PSEC's control investments reminded me of Compass Diversified Holdings (NYSE:CODI), which is not a BDC, but rather a BDC-like Grantor Trust.
Nicolas Marshi describes the difference in an April 2011 SA article: Unlike a BDC which typically lends to third party borrowers, and may own a minority equity interest in some of its borrowers, Compass owns a controlling interest in all of its portfolio companies and consolidates all the businesses on its balance sheet. However, the BDC Reporter has tracked the company for years because it shares many traits with its BDC brethren: i) involved in financing the private company middle market; ii) provides substantial disclosure on portfolio holdings; iii) pays a regular dividend.
While control investments may enhance a BDC's long term profit, equity management can be labor intensive. This involvement, rather than simply loaning money, drives the need for strong staffing. PSEC has twelve in-house attorneys, eight in-house tax professionals and about the same number of CPAs.
Eliasek said the results of their control investments often are not immediately accretive to earnings, but over time shareholders are rewarded with equity upside.
Loan Originations, the Calling Center and Deal Flow
I asked Eliasek several questions regarding loan originations:
PSEC claims (as do virtually all BDCs) that loan requirements are stringent and far more deals are turned down than actually close. It gives the impression that many companies or sponsors are seeking loans from PSEC and PSEC is very selective about investments that are made. Yet, two factors seem to contradict this. One is the rapid growth of PSEC's assets under management in recent years. The other is PSEC's use of staff members dedicated to making "cold calls" to businesses to seek out potential loans. How have you maintained high loan quality in light of the rapid growth and the aggressive solicitation of loans via cold calls?
Has loan origination slowed down in recent months? If so, has this been driven by fewer opportunities due to economic reasons? Or, is it an intentional decision by PSEC to slow the growth?
Eliasek's response provides insight into PSEC's "deal flow." The word "scale" appears regularly in their most recent earnings release and earnings call. Eliasek said they "look under rocks" to find suitable investments and their call center as a competitive advantage because "we need to look at more deals, not fewer." They annually consider 4,000 potential loans or investments but only close on 1% to 2% of these.
Many calls are made to persons in PSEC's "deal flow" network, which includes small intermediaries such as broker/dealers, boutique banks, private equity investors, and persons who have helped them connect with previous investments or who have been loan recipients or partners in previous deals. PSEC has 75,000 persons on their e-mail distribution list. These persons are notified each time a deal is closed. This keeps PSEC in front of these persons and it sometimes results in a conversation with PSEC about potential loans or equity investments.
By finding deals "under rocks," PSEC sometimes is the only BDC consulted by a potential client. PSEC calls intermediaries, "orphaned micro cap public companies," management teams past and present and 800 private equity funds in their data base. When I first heard about PSEC's call center, I envisioned random cold calls made to small businesses. Eliasek said potential clients are contacted where there is some "conviction around those calls" after conversation with one or more contact persons in their deal flow network. He said PSEC may do 50 deals a year out of thousands of opportunities from many different sources. He said, "There is no quality without quantity."
As for the recent slowdown in loan originations, Eliasek said part of it is seasonal, because sometimes activity is slower during the summer. Originations can be "lumpy," and he pointed out that PSEC had $2 billion in originations in the first eight months of 2014 and he said they have $400 million of potential investments in their pipeline (as was mentioned in their FY Q4 earnings released on August 25).
The Sale of AirMall
Regarding PSEC's sale of AirMall, I asked:
What was the sales price? Did PSEC or an affiliated CLO provide financing to the purchaser?
Eliasek declined to give the price, saying sometimes the buyer will request a delay in making such an announcement. He said the price will be disclosed in their 10-Q during the first week of November. He said PSEC did not provide financing for the deal.
Accounting for Troubled Assets
Issues have been raised on Seeking Alpha about PSEC's accounting for troubled assets. I asked this question:
A few months ago there was much conversation in the Seeking Alpha community about PSEC's claim that there had been no defaults. It appeared to me that PSEC had put itself in a vulnerable position by making the "no default" claim when closer scrutiny revealed the common practice among BDCs of re-financing trouble loans or selling the assets at a loss to avoid default. Have you found more transparent ways of talking about how you sell or refinance less-than-stellar investments?
Eliasek said one way to manage a loss rate is to quickly sell problem loans. This takes the asset off the books. He said PSEC typically does not do this but rather tries to maximize recovery by doing such things as bringing in new management, infusing additional capital where needed, and then recapitalizing the investment at some point in the future. He said if PSEC is in a control position, it can move more quickly to accomplish this workout.
He gave the example of Iron Horse, a Canadian coil tubing company that ran into difficulty. PSEC installed new management and sent one of their senior leadership team members to a remote part of Alberta every two weeks to facilitate the workout. They were able to recover their investment and sell the company at a 12% return, which "wasn't a home run, but it wasn't a loss, either."
At the conclusion of Eliasek's prepared remarks during their recent earnings call, he said: "Our credit quality continues to be stable. Non-accruals, as a percentage of total assets, stood at 0.1% in June 2014, down from 0.3% in June 2013 and 1.9% in June 2012." I think this element of the quarterly earnings release is a helpful addition to PSEC's reporting.
Prospect's Debt Structure
We had a wide-ranging discussion, some of which re-stated information that is available in their recent earnings release and earnings call. Eliasek said investors should pay closer attention to the "right side of the balance sheet," echoing a statement made by CFO Brian Oswald during the earnings call, noting that "As of June 2014, we held more than $4.9 billion of our assets as unencumbered assets, representing approximately 80% of our portfolio. The remaining assets are pledged to Prospect Capital Funding LLC which has a AA-rated $877.5 million revolver with 29 banks and with a $1 billion total size accordion feature at our option."
Eliasek said the revolver (representing 20% of assets) is secured by assets in the LLC, which are separate from PSEC assets. This is one reason PSEC has an investment grade rating. From Oswald's prepared statement in the earnings call: "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 BBB rating from S&P and a BBB+ rating from Kroll."
On page 48 of their recent 10-K filing, PSEC reported: "We may distribute taxable dividends that are payable in part in our stock. The IRS has issued a private letter ruling on cash/stock dividends paid by us if certain requirements are satisfied, and the ruling permits us to declare such taxable cash/stock dividends, up to 80% in stock, with respect to our taxable years ending August 31, 2014 and August 31, 2015."
I asked Eliasek if this was a routine filing. He said, "Yes, it is a routine matter." He explained that the IRS previously granted this option on an ongoing basis to companies that are required to pay out 90% of their earnings in dividends (such as BDCs and REITs), but now the IRS provides a private letter to companies that is in effect for only two years. Eliasek said PSEC has never exercised this option but it helps maintain their investment grade rating because it gives the company added flexibility. He compared it to the process of being granted permission to issue stock at less than net asset value. The less-than-NAV permission is granted only for one year at a time, so it too is a routine filing even if there are no plans for such a stock issuance.
The Dividend and the Recent Earnings Call
I did not ask questions that I knew would be deflected--such as whether the dividend is secure beyond this calendar year. PSEC's pattern of announcing intended dividends many months in advance has given some investors a sense of security about the company, as in "They must be doing okay. They've pre-announced dividends for several months out." During the question and answer segment of PSEC's recent earnings call, analysts asked management about how much of the "2013 earnings spillover" remained available to make up any shortfall between net income and the projected dividend. Since PSEC's yield is a major attraction to investors, I will conclude this article by citing the dividend-related dialogue between analysts and PSEC management in their August 26 earnings call.
From Greg Mason of KBW: "For the past two years, you've always released ... the next three months dividend announcement with the earnings ... simultaneously. And we didn't see that last night, making the dividend announcement with the earnings. What should we think about that? Is there anything we should read into that?
CEO John Berry replied, "Not really Greg. The Board has announced dividends going out through the end of December which is a pretty long runway and we thought we would just digest information from the market and how the portfolio is performing and have more to say about that next quarter. We also, I would add to that, continue to have spill back income, as Brian had said earlier, as a bank so as to the value of dividends for the future as well."
From Christopher Knowland of MLV & Company: "Back to the dividend for one second. Did Brian mention what the spillover income was? Because I might have missed it."
CFO Brian Oswald replied, "I only disclosed what we had disclosed which was through August of last year. I mean a good estimate would be to take whatever our dividends are in excess of NII and reduce that amount by that difference."
From Christopher Knowland: "And then going out beyond December in terms of the dividend, given that the company has not covered the dividend for any quarter for fiscal 2014. Is a return of capital part of the plan just to maintain the payout, or is the policy, once the spillover income is exhausted, adjust to the right size of dividend for the earnings?"
CFO Brian Oswald replied, "Our policy strategy is to focus on paying out dividends out of taxable earnings and to avoid return on capital distributions over the long term, and we do have a spillback available to us to support that. But we also have catalysts which we hope will drive our earnings going forward."
From Christopher Knowland: "Grier, as a follow up to that, incrementally, back of the envelope estimate, you needed about 100 basis point improvement in overall yield of net investment income to cover the dividend, do you think all those initiatives that you are outlining could achieve that, achieve a full coverage of the dividend?"
COO Grier Eliasek replied, "We'll have more to say about that Chris in the future because some of them are further along. For example, the reduction in our financing, as Brian indicated, we hope to have more say about that in the near future. Some of those are a little bit longer-term initiatives."
As stated earlier, I have no position in PSEC. In light of this conversation with Grier Eliasek, I am reconsidering my earlier position to invest in no externally managed BDCs. The two regular Seeking Alpha BDC writers that I follow, BDC Buzz and Nicolas Marshi, both invest in and/or recommend externally managed BDCs as well as internally managed BDCs. Eliasek gave two related reasons for preferring the external model: the recruitment of talent and the advantages of sector diversified control investments. I am not in a position to compare the talent at internally managed BDCs vs. externally managed BDCs, nor am I in a position to weigh the advantages and disadvantages that come with size and sector diversity. Eliasek effectively lays out PSEC's case for scale.
PSEC's 25% control investment component of the portfolio is similar to, but more extensive than, Manuel Henriquez' description of the "equity kicker" component that represents about 10% of the portfolio of Hercules Technology. I appreciated Eliasek's elaboration of how a control position gives PSEC options for working out a troubled debt or equity investment. For me, the most helpful part of the interview was the insight provided by Eliasek into their call center and their extensive "deal flow" network.
I'm long three internally managed BDCs: TCAP, MAIN and HTGC. I have no way of knowing whether they are hindered in their recruitment of talent because they are internally managed, as asserted by Eliasek. One way to measure a BDC's performance is how well a company is growing dividends covered by net income. Here are data from the past five years as provided by Morningstar:
|PSEC (FY 2010-14)||.32/1.33||1.38/1.21||1.67/1.22||1.07/1.28||1.06/1.32|
I enjoyed my conversation with Grier Eliasek. I appreciate his willingness to take the time to answer my questions. He is a gracious and effective representative for Prospect. The Prospect management team is to be commended for making a strong effort to get their story out to the investment community. My reading of recent Prospect-related comments on Seeking Alpha indicates that the investor community is eagerly waiting to see if Prospect's well-articulated story will result in growing dividends covered by net investment income, or NII. I wish them every success.