Prospect Capital Corporation (NASDAQ:PSEC) Q2 2018 Earnings Conference Call February 8, 2018 11:00 AM ET
John Francis Barry - Chairman & Chief Executive Officer
Brian Oswald - Chief Financial Officer & Chief Compliance Officer
Grier Eliasek - President & Chief Operating Officer
Leslie Vandegrift - Raymond James
Good day and welcome to the Second Fiscal Quarter Earnings Release and Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to John Barry, Chairman and CEO. Please go ahead, sir.
John Francis Barry
Thank you, Rachel. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Brian Oswald, our Chief Financial Officer. Brian?
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 website, prospectstreet.com.
Now, I will turn the call back over to John.
John Francis Barry
Thank you, Brian. For the December 2017 fiscal quarter, our net investment income, or NII was $73.2 million, or $0.20 per share, up $0.02 from the prior quarter and exceeding our current dividend rate by $0.02 as well. NII increased due to better loan performance and a reduction in administrative overhead expenses.
Executing our plan to preserve capital, reduce risk and avoid chasing yield through investments deemed too risky, with a poor risk return profile at this point in the economic cycle, we booked originations below our level of repayments this quarter. We remain committed to our historic credit discipline. We currently have a robust pipeline of potential investments in our target range for credit quality and yield. We believe our disciplined approach to credit will serve us well in the coming years, just as that disciplined approach has served us well in past years.
In the December 2017 quarter, we also maintained our objective to protect risk with a prudent net debt to equity ratio of 60.2%, down a 11.4% from the prior quarter. Our net income was $121.7 million, or $0.34 per share, up $0.31 from the prior quarter, as a result of net investment income in excess of dividends, and an increase in the fair market value of certain investments. We have multiple disciplined strategies in place with a goal of enhancing our future income.
On the asset management side, we plan on executing on a robust pipeline of new originations; improving cash flows in our structured credit portfolio through extensions, refinancings, and calls; optimizing NPRC’s online lending business through asset selection, securitizations and refinancing; enhancing NPRC’s multi-family real estate portfolio through realizations and supplemental financings; improving controlled investment operating performance and enhancing yields to higher floating rate LIBOR-based rates.
On the liability management side, we plan on lowering our weighted average cost of capital through a combination of increased revolver utilization and lower coupon, new term issuance, while managing our maturity risk through continued liability laddering issuance. We are announcing monthly cash distributions to shareholders of $0.06 per share for February, March and April, representing 117 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in May.
Since our IPO 14 years ago through our April 2018 distribution and our current share count, we will have paid out $16.44 per share to our original shareholders, exceeding $2.5 billion in cumulative distributions to all shareholders. Our NAV stood at $9.08 per share in December 2017, up $0.16 from the prior quarter.
Our balance sheet as of December 31, 2017 consisted of 89.3% floating rate interest-earning assets and 99.9% fixed rate liabilities, positioning us to benefit from rate increases. Our recurring income as measured by our percentage of total investment income from interest income was 94.4% in the December 2017 quarter, demonstrating our continued dedication to recurring income compared to one-time structuring fees.
We believe there is no greater alignment between management and shareholders than for management to purchase a significant amount of stock, particularly when management has purchased stock on the same basis as other shareholders in the open market.
Prospect management is the largest shareholder in Prospect and has never sold a share. Management and affiliates on a combined basis have purchased at cost over $350 million of stock in Prospect, including over $285 million since December 2015.
Our management team has been in the investment business for decades, with experience handling both challenges and opportunities provided by dynamic, economic and interest rate cycles. We have learned when it is more productive to reduce risk than to reach for yield, and the current environment is one of those time periods. At the same time, we believe the future will provide us with substantial opportunities to purchase attractive assets, utilizing the dry powder we have built and reserved.
Thank you. I will now turn the call over to Grier.
Thanks, John. Our scale business with over $6 billion of assets and undrawn credit continues to deliver solid performance. Our experienced team consists of approximately 100 professionals, representing one of the largest 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 and direct non-sponsor lending, Prospect sponsored operating and financial buyouts, structured credit, real estate yield investing and online lending.
As of December 2017, our controlled investments at fair value stood at 37.1% of our portfolio. This diversity allows us to source a broad range and high volume of opportunities then select in 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. 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.
As of December 2017, our portfolio at fair value comprised 44.6% secured first lien, 21.3% secured second lien, 17.3% structured credit with underlying secured first lien collateral, 0.6% unsecured debt and 16.2% equity investments, resulting in 83% of our investments being assets with underlying secured debt benefiting from borrower pledge collateral.
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 December 2017, up 0.7% from the prior quarter. We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as such positions generate distributions. We have 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.
As of December 2017, we held 122 portfolio companies with a fair value of $5.42 billion. We also continued to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration. The largest is 13.3%.
As of December 2017, our asset concentration in the energy industry stood at 3.1% and our concentration in the retail industry stood at zero percent. Non-accruals as a percentage of total assets stood at approximately 1.2% in December 2017, down 0.9% from the prior quarter.
Our weighted average portfolio net leverage stood at 4.44 times EBITDA, up from 4.32 the prior quarter. Our weighted average EBITDA per portfolio company stood at $60.5 million in December 2017, up from $49.2 million in September 2017. The majority of our portfolio consists of sole agented and self-originated middle-market loans.
In recent years, we have perceived the risk-adjusted reward to be higher for agented, self-originated and anchor investor opportunities, compared to the non-anchor broadly syndicated market, causing us to prioritize our proactive sourcing efforts. Our differentiated call center initiative continues to drive proprietary deal flow for our business.
Originations in the December 2017 quarter aggregated $739 million. We also experienced $1.042 billion of repayments and exits as a validation of our capital preservation objective, resulting in net repayments of $304 million.
During the December 2017 quarter, our originations comprised 56% agented sponsor debt; 32% non-agented debt, including early look anchoring and club investments; a 11% real estate; and 1% operating buyouts. To date, we have made multiple investments in the real estate arena through our private REITs, largely focused on multi-family stabilized yield acquisitions with attractive 10-year financing.
In the June 2016 quarter, we consolidated our REITs into NPRC. NPRC’s real estate portfolio has benefited from rising rents, strong occupancies, high-returning value-added renovation programs, and attractive financing recapitalizations, resulting in an increase in cash yields as a validation of this income growth business alongside our corporate credit businesses.
NPRC has exited completely certain properties, including Vista, Abbington, Bexley Mission Gate and Central Park with an objective to redeploy capital into new property acquisitions. We expect both recapitalizations and exits to continue and NPRC has an additional exit pending with attractive expected realized returns.
Since September 30, 2017, NPRC has closed three acquisitions with a repeat property management relationship, with a strong track record, with more acquisitions expected in the future. In addition to NPRC’s significant real estate asset portfolio, over the past few years, NPRC and we have grown our online lending portfolio with a focus on super-prime, prime and near prime consumer and small business borrowers.
In the past five years, we and NPRC have closed six bank credit facilities and three securitizations, including in the June 2017 quarter NPRC’s second consumer securitization to support the online business. NPRC is currently evaluating a potential third consumer securitization. NPRC is focused on expanding its most productive online lending platform activity, while refinancing and redeploying capital from other online platforms.
Our structured credit business performance has exceeded our underwriting expectations, demonstrating the benefits of pursuing majority stakes, working with exceptional management teams, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities.
As of December 2017, we held $940 million across 43 non-recourse structured credit investments. The underlying structured credit portfolios comprised over 2,200 loans and a total asset base of over $19 billion.
As of December 2017, our structured credit portfolio experienced a trailing 12-month default rate of 77 basis points, up 22 basis points in the prior quarter and 128 basis points less than the broadly syndicated market default rate of 205 basis points. This 128 basis point outperformance was up from 98 basis points in the September 2017 quarter.
In the December 2017 quarter, this portfolio generated an annualized cash yield of 17%, down 1.3% from the prior quarter, and a GAAP yield of 12.5%, up 0.1% from the prior quarter.
As of December 2017, our existing structured credit portfolio has generated $1.08 billion in cumulative cash distributions to us, representing 73% of our original investment. Through December 2017, we’ve also exited 11 investments, totaling $291 million, with an average realized IRR of 16.1% and cash and cash multiple of 1.48 times.
Our structured credit portfolio consists entirely a majority-owned positions. Such positions can enjoy significant benefits, compared to minority holdings in the same tranche. In many cases, we received fee rebates because of our majority position. As a majority holder, we control the ability to call a transaction in our sole discretion in the future, and we believe such options add substantial value to our portfolio.
We have the option of waiting years to call a transaction in an optimal fashion rather than when loan asset valuations might be temporarily low. We as majority investor can refinance liabilities on more advantageous terms, remove bond baskets in exchange for better terms from debt investors in the deal and extend or reset the investment period to enhance value. Our structured credit equity portfolio has paid us an average 19.3% cash yield in the 12 months ended December 31, 2017.
So far in the current March 2018 quarter, we booked $182 million in originations and received repayments of $0 million, resulting in net originations of $180 million. Our originations have comprised 53% agented sponsor debt, 41% non-agented debt, 3% online lending, 2% structured credit and 1% real estate.
Thank you. I’ll now turn the call over to Brian.
Thanks, Grier. We believe our prudent leverage diversified access to matched-book funding, substantial majority of unencumbered assets and weighting towards 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 over 25 years into the future, while the significant majority of our loans float with LIBOR, providing potential upside to shareholders as interest rates rise. We’re a leader and innovator in our marketplace. We were the first company in our industry to issue a convertible bond, develop a notes program, issue an institutional bond, acquire another BBC and many other first.
Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry, which we have taken towards construction of the right-hand side of our balance sheet.
As of December 2017, we held approximately $4.6 billion of our assets as unencumbered assets, representing approximately 78% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, which has a AA rated $885 million revolver with 21 banks, with a $1.5 billion total size accordion feature at our option. The revolver is priced at LIBOR plus 225 basis points and revolves until March 2019, followed by one year of amortization with interest distributions continuing to be allowed to us.
Outside of our revolver and benefiting from our unencumbered assets, we’ve issued at Prospect Capital Corporation multiple types of investment-grade unsecured debt, including convertible bonds, institutional bonds, baby 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 an investment-grade BBB rating from Kroll and an investment-grade BBB minus rating from S&P. We’ve now tapped the unsecured term debt market on multiple occasions to ladder our maturities and extend our liability duration more than 25 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we’ve substantially reduced our counterparty risk over the years.
We have refinanced four non-program term debt maturities in the past three years, including our $100 million baby bond in May 2015, our $150 million convertible note in December 2015, our $167.5 million convertible note in August 2016, and our $50.7 million convertible note in October 2017, the latter of which we had significantly repurchased in the June 2017 quarter.
In the June 2017 quarter, we issued a 4.95%, $225 million July 2022 convertible bond, utilizing a substantial amount of the proceeds to repurchase bonds maturing in the upcoming year. We have also called $222 million of our program notes maturing through November 2019.
For the remainder of calendar year 2018, we have liability maturities of $140 million. Our $885 million revolver is currently undrawn. If the need should arise to decrease our leverage ratio, we believe we could slow originations and allow repayments and exits to come in during the ordinary course, as we demonstrated in the first-half of calendar year 2016 during market volatility.
We now have seven separate unsecured debt issuances aggregating $1.7 billion, not including our program notes with maturities ranging from March 2018 to June 2024. As of December 31, 2017, we had $838 million of program notes outstanding with staggered maturities through October 2043.
Now, I’ll turn the call back over to John. We’re happy to answer any questions. Thank you.
John Francis Barry
Thank you, Brian. We can now answer any questions.
Thank you. We will now begin the question-and-answer session [Operator Instructions] The first question comes from Leslie Vandegrift with Raymond James. Please go ahead.
Hi, good morning, and thank you for taking my questions. First, on the CLO effective yields, I noticed on a few of them in the footnotes, they are marked as 0% effective yield, and it says that’s because you do not expect being able to get the cost of the investment out of there. Can you explain how that’s different in the notation of the normal non-accruals and also the major changes quarter-over-quarter in the cent [ph] CLO and Madison Park CLO?
John Francis Barry
Okay. Well, Leslie, that’s a great question. Thank you very much. I’m going to ask Brian to take that one on. Brian?
John Francis Barry
Brian and – by the way, Brian and Grier, because I think, there’s both an accounting and a – not that Brian is limited to accounting, but an accounting and a business answer. So why don’t you start Brian and then Grier can finish up.
Okay. The way that the – this may get a little complicated. But the way that the recognition of income on the CLOs work is based on an expected cash flows on the underlying securities, which then generates cash flows to the holders of the subordinated notes.
When there’s changes in the assumptions, there is the effect of changing the future cash flows or the expectations for future cash flows. And you have to excuse us, we have lot of noise occurring outside here. The – when that happens, there’s a potential that the expectations for repayment of the remaining amount outstanding may be diminished or reduced to zero. When that happens, the CLO does not recognize any additional yield until there’s a change in the assumptions, and there’s an expectation that all principal plus some interest may be recorded. I hope that helps.
Is it the – yes Is it the principal that you are trying to get repaid fully on other costs there, because the footnote says you don’t expect costs back?
It’s the cost basis.
Okay. All right.
Leslie, let me add to that answer. So and I think it – we can talk about kind of broader strategy in context as well. What’s happening, of course, in the credit markets due in significant part to fed activity and an increase short-term yields or short-term interest rates is a flood of capital into anything labeled floating rate, as we all know, which is causing significant downtick in assets spreads, which happens reasonably predictably this part of the cycle.
So this is where or having substantial weight in these deals is important and what’s attractive about this spread business, because we can recapture on the liability side of the ledger a reduction in liability borrowing costs to offset, some cases, more than offset asset spread compression.
So we are aggressively pursuing this strategy of reducing our weighted average cost of liabilities in our structured credit book, while also simultaneously reducing risk by extending tenor.
So for deals that would otherwise be coming due in one year or two years in the natural course, we’re expanding them years into the future, which is a significant risk reducer, because what you don’t want to have in this business is the ending of a deal during a recession, or during a spike and default and a downtick in loan values, a suboptimal time to be realizing investments. So you want to have significant option value to your equity holding.
So what we’re doing by resetting, aka extending the deals reduces our risk for the reason I just mentioned of extending tenor and enhances our reward at the same time by reducing the weighted average cost of liabilities. Certain deals that are pending and it does take weeks and months to get these resets done, you have to get the deals rerated by the rating agencies, you have to get into the proper queues, with the rangers, with debt providers.
It’s not a snap your fingers instant, do it in one afternoon type of activity across all 43 deals, and there’s a lot that goes on in marking the liabilities and modeling out what’s appropriate and, of course, negotiating hardest or the best deal for our benefit.
So while those deals are pending until the deal is done, we don’t assume for valuation or accounting purposes that a reset has occurred. So that’s why you see in some cases, we’re not accruing income for such deals. But once we pursue a reset, which by the way, has incremental IRR is attached to it, and many cases of a triple-digit variety that’s how creative they are in addition to reducing our risk by, again, by extending tenor.
In terms of the two specific deals you asked about for the the cent deal, we had a significant benefit in the underlying value of our equity positions that we’ll receive from restructurings. There has been a significant boost out there in the energy side of the ledger.
You saw that in our middle-market book with an improvement in energy positions. And you’re seeing that in a broadly syndicated market, where there has been a significant benefit to situations, which – the majority of our collateral managers did, which was to hold on to energy paper as opposed to crystallized losses selling at the bottom, the cycle has turned somewhat. People are cautiously optimistic. And by holding rather than liquidating the bottom, there has been a benefit for a recovery that we hope to see continue.
For the Madison Park IX deal, that deal is essentially in liquidation with minimal assets remaining. So hopefully, that helps to answer your questions.
It does. Thank you. I appreciate the color on that. And then my next question is actually, you mentioned it in the prepared remarks on insider buying. Obviously, there has been a lot since the previous earnings call from the outstanding filings, I think, about 28.3 million shares so far the sense, I guess, the beginning of November. Now that’s a lot more than even was done in first quarter 2016, when we had the tradeoff in the market. So just curious, what is driving that large purchase position?
John Francis Barry
Well, why don’t I address that Leslie, since I’m the major person. I would say that, when I see somebody buying something, I can choose from bunch of observations and a bunch of conclusions. Usually, it’s because the person thinks, he or she is getting value equal to or greater than the price being paid. That would be true buying a car, or a house, or certainly a financial instrument, right?
John Francis Barry
What motivates you to buy a share of stock? Anything besides the price?
Well, the question, I guess, it was the comparison between in first quarter 2016, the level of purchases were much lower than the stock was trading just as low, if not lower at certain points compared to NAV. So why NAV is more the question, and why this volume?
John Francis Barry
I guess, I would say, speaking only for myself, I happen to believe, the stock is a good buy.
John Francis Barry
If I didn’t, I don’t know why I would be spending my money on it.
Okay, great. Thank you. And then on the yields quarter-over-quarter, you talked about the large jump incrementally. Is any of that due to some outside fee income in there, or are there nonrecurring that you can specifically call out?
John Francis Barry
With a large jump, are you referring…?
And the 70 basis point, I believe you said jump in yields on debt quarter-over-quarter?
John Francis Barry
Brian, do you want to address that, and then Grier?
I’ll take that. Leslie, we have been have it for sometime now of reporting our interest income or interest revenue as a percentage of total revenue which, of course, folks then calculate for themselves as well, that’s make it easier to point out that our business for quite a while now has not been so dependent on one-time structuring fee income, which can be a driver of a, let’s say, a smaller version company that’s growing and booking fees and that are highly the nonrecurring variety, that’s not the case with our business, we’re at over 94% interest as a percentage of total investment income.
The increase in the yields in the quarter, which was – what you quoted was a net increase, that does continue to be asset spread competition in the marketplace. You’ve had an increase in LIBOR, which has helped us submit again. But really because of the improvement in yields from the improvement in certain portfolio companies restored to accruing status, as well as a key driver there, so multiple factors.
Okay. And I – oh, perfect. And I guess, my last little question is on that, the two that came back on to an accruing status, Spartan and Venio, just some color around those changes?
Sure. Well, Spartan is an energy services company. And as I’m sure, as everybody on this phone call knows, there has been a significant recovery in the oil patch with the most volatile downward segment arguably being energy in oilfield services, and the same is true on the recovery side as well.
So you’ve seen businesses in that segment. They were generating tens of millions of EBITDA, they went to zero a couple years ago. Now we’re back to generating tens of millions of EBITDA. And that’s quite a peak mind you, you saw in 2014, but substantial recovery.
We have levered those businesses or purchased in a couple of cases at recently low multiples of then profitability. So it doesn’t take much of an uptick to get back into significant account for recovery mode and maybe even net gains for areas, where we own upside. So that covers Spartan.
In the case of Venio, that’s a – more of a financial services, really business services company, less of a macro reason there and more just specific, company-specific reasons for improved performance.
All right. Thank you. I appreciate you answering my questions.
John Francis Barry
Thank you, Leslie.
This concludes our question-and-answer session. I would like to turn the conference back over to John Barry for any closing remarks.
John Francis Barry
Okay. Well, thank you, everyone, for joining our call. Have a wonderful afternoon. Bye now.
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.