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Edited Transcript of PSEC earnings conference call or presentation 7-Nov-19 4:00pm GMT

Q1 2020 Prospect Capital Corp Earnings Call

New York Nov 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Prospect Capital Corp earnings conference call or presentation Thursday, November 7, 2019 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* John Francis Barry

Prospect Capital Corporation - Chairman & CEO

* Kristin Lea Van Dask

Prospect Capital Corporation - CFO, Treasurer, Secretary & Chief Compliance Officer

* Michael Grier Eliasek

Prospect Capital Corporation - President, COO & Director

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Conference Call Participants

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* Matthew Alan Tjaden

Raymond James & Associates, Inc., Research Division - Research Associate

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Presentation

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Operator [1]

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Good day, and welcome to the Prospect Capital Corporation First Fiscal Quarter Earnings Release Conference Call. (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.

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [2]

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Thank you, Ali. Joining me on the call this morning are Grier Eliasek, our President and Chief Operating Officer; and Kristin Van Dask, our Chief Financial Officer. Kristin?

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Kristin Lea Van Dask, Prospect Capital Corporation - CFO, Treasurer, Secretary & Chief Compliance Officer [3]

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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 and our 10-Q filed previously and available on the Investor Relations tab on our website, prospectstreet.com.

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

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [4]

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Thank you, Kristin. For the September 2019 quarter, our net investment income, or NII, was $71.1 million or $0.19 per share, the same as the prior quarter and again exceeding our current dividend rate of $0.18 per share. Our ratio of NII to distributions was 107%. In the September 2019 quarter, our net debt-to-equity ratio was 66.3%, down 3.7% from the prior quarter as we continue to maintain a prudent leverage profile and cautious approach to capital deployment in the current environment. Our net income for the quarter was $18.1 million or $0.05 per share, a decrease of $0.06 from the last quarter, primarily due to a decrease in portfolio valuations during the September 2019 quarter.

We have multiple disciplined strategies in place with the goal of enhancing our future risk-adjusted income. On the asset management side, we plan on executing on our pipeline of new originations; improving cash flows in our structured credit portfolio, including through extensions, refinancings and calls; enhancing NPRCs, largely multifamily real estate portfolio, including through realizations, refinancings and supplemental dividend recapitalizations; increasing results at controlled investments, including improving operating performance, closing accretive bolt-on acquisitions and monetizing at attractive exit points. On the liability management side, we plan on protecting against maturity risk through continued liability laddering, issuance of diverse instruments to a diverse investor base while managing both our cost of capital and leverage profile.

We are announcing monthly cash distributions to shareholders of $0.06 per share for each of November, December and January, representing 138 consecutive shareholder distributions. We plan on announcing our next series of shareholder distributions in February 2020. Since our IPO, through our February 2020 distribution at our current share count, we will have paid out $17.70 per share to original shareholders, aggregating approximately $3 billion in cumulative distributions to all shareholders.

Our NAV stood at $8.87 per share in September, down $0.14 from the prior quarter. Our balance sheet as of September 2019 consisted of 86.9% floating rate assets and 95.2% fixed rate liabilities. In recent months, we have trimmed our cost of term debt issuance commensurate with reductions in treasuries while also retiring more expensive upcoming maturities. Our percentage of total investment income from interest income was 90.2% in the September 2019 quarter, a decrease of 2% from the prior quarter.

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 only on the same basis as other shareholders in the open market. Prospect management is the largest shareholder in Prospect and has never sold a single share. Management and affiliates on a combined basis have purchased, at cost, approximately $400 million of stock in Prospect.

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, including through our recent reduction in leverage during the September 2019 quarter.

Thank you. I will now turn the call over to Grier.

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Michael Grier Eliasek, Prospect Capital Corporation - President, COO & Director [5]

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Thank you, 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 September 2019, our controlled investments at fair value stood at 44% of our portfolio, up 0.2% from the prior quarter. 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 nonbank 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 September 2019, our portfolio at fair value comprised 43.3% secured first lien, 23.1% secured second lien, 15% subordinated structured notes with underlying secured first lien collateral, 1% rated secured structured notes, 0.8% unsecured debt and 16.8% equity investments, resulting in 82.4% 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. In our performing interest-bearing investments, we're generating an annualized yield of 12.7% as of September 2019, down 0.4% 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've continued to prioritize 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 September 2019, we held 125 portfolio companies, down 10 from the prior quarter due to repayments and exits with a fair value of $5.45 billion. We also continue to invest in a diversified fashion across many different portfolio company industries with no significant industry concentration, the largest is 15.7%. As of September 2019, our asset concentration in the energy industry stood at 2.7% and our concentration in the retail industry stood at 0%. Nonaccruals as a percentage of total assets stood at approximately 2.4% in September 2019, a decrease of 0.5% from the prior quarter.

Our weighted average portfolio net leverage stood at 4.69x EBITDA, up 0.02 from the prior quarter. Our weighted average EBITDA per portfolio company stood at $62.0 million in September 2019, up from $60.7 million in the prior quarter. Originations in the September 2019 quarter aggregated $95 million. We also experienced $245 million of repayments and exits as a validation of our capital preservation objective and sell-down of larger credit exposures, resulting in net repayments of $151 million.

During the September 2019 quarter, our originations comprised 79% nonagented debt, including early look anchoring and club investments; 8% corporate yield buyouts; 7% rated secured structured notes; and 6% agented sponsored debt.

To date, we've deployed significant capital in the real estate arena through our private REIT strategy largely focused on multifamily workforce, stabilized yield acquisitions with attractive 10-year plus financing.

NPRC, our private REIT, has real estate properties that have 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 21 properties, with an objective to redeploy capital into new property acquisitions, including with repeat property manager relationships. We expect our exits to continue and have identified multiple additional properties for potential exit in calendar years 2019, 2020 and beyond. Our structured credit business has delivered attractive cash yields, demonstrating the benefits of pursuing majority stakes, working with world-class management teams, providing strong collateral underwriting through primary issuance and focusing on attractive risk-adjusted opportunities.

As of September 2019, we held $818 million across 39 nonrecourse subordinated structured notes investments. These underlying structured credit portfolios comprised around 1,800 loans and a total asset base of over $18 billion. As of September 2019, the structured credit portfolio experienced a trailing 12-month default rate of 40 basis points, representing 89 basis points less than the broadly syndicated market default rate of 129 basis points.

In the September quarter, this portfolio generated an annualized GAAP yield of 15.5%. As of September 2019, our subordinated structured credit portfolio has generated $1.1 billion in cumulative cash distributions to us, representing around 81% of our original investment. Through September 2019, we've also exited 9 investments, totaling $263 million with an average realized IRR of 16.7% and cash-on-cash multiple of 1.5x.

Our subordinated structured credit portfolio consists entirely of majority-owned positions. Such positions can enjoy significant benefits compared to minority holdings in the same tranche. In many cases, we receive 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 a 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.

We completed 26 refis and resets since September -- since December, rather, 2017. So far in the current December quarter, we've booked $19 million in originations and have received repayments of $23 million, resulting in net repayments of $4 million. Our originations have comprised 53% real estate, 25% nonagented debt and 22% agented sponsored debt.

Thank you. I'll now turn the call over to Kristin.

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Kristin Lea Van Dask, Prospect Capital Corporation - CFO, Treasurer, Secretary & Chief Compliance Officer [6]

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Thanks, Grier. 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 liabilities extending 24 years into the future. We are 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 under a bond ATM, acquire another BDC and many other lists of firsts. Shareholders and unsecured creditors alike should appreciate the thoughtful approach differentiated in our industry which we have taken toward construction of the right-hand side of our balance sheet.

As of September 2019, we held approximately $4.02 billion of our assets as unencumbered assets, representing approximately 72% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, where in September we completed an extension of our revolver to a refreshed 5-year maturity. We currently have $1.0775 billion of commitments from 30 banks with a $1.5 billion total size accordion feature at our option. The facility revolves until September 2023, followed by a 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, including in the past 2 years, 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 investment-grade BBB rating from Egan-Jones and an investment-grade BBB negative rating from S&P and an investment-grade Baa3 rating from Moody's. So a total of 4 investment-grade ratings.

We have now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 24 years. Our debt maturities extend through 2043. With so many banks and debt investors across so many debt tranches, we have substantially reduced our counterparty risk over the years.

In the September 29 quarter, we repurchased $47 million of our April 2020 notes as well as $144 million of our program notes. We also continued our weekly programmatic Internet issuance.

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 have demonstrated in the first half of the calendar year 2016 during market volatility. We now have 8 separate unsecured debt issuances aggregating $1.5 billion, not including our program notes, with maturities extending to June 2029. As of September 2019, we had $657 million of program notes outstanding with staggered maturities through October 2043.

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

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [7]

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Thank you very much, Kristin. We can now answer any questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Matt Tjaden with Raymond James.

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Matthew Alan Tjaden, Raymond James & Associates, Inc., Research Division - Research Associate [2]

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I'm on the line with -- or for Robert. So first question, and a couple leading off of it will kind of be related to LIBOR. So last quarter, I know we kind of talked about a decreasing rate environment can, to some, signal softening economic conditions. Have you all been seeing any of that in your underlying portfolio companies?

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [3]

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Well, you want to take that, Grier?

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Michael Grier Eliasek, Prospect Capital Corporation - President, COO & Director [4]

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Sure. Well, look, I'm not sure we want to wax poetic about macroeconomic conditions, but obviously LIBOR went down because of Fed cutting based on economic weakness, and more in the manufacturing and selected part of the corporate sector, and the consumer continues to be very strong. And anything that's consumer-centric in our book, for example our consumer finance businesses, are putting up some very nice numbers today.

So it's uneven, I would say, like the rest of the economy, areas of manufacturing and industrial and energy are challenged because of the tariff situation, but we have very little exposure to those segments today. Energy is less than 3% of our book and is really a pittance exposure compared to where it was many, many years ago in our book.

So we're not really seeing a dramatic slowdown, but we are concerned, given the length of the bull market that we've had to date. We're also concerned because of structures we've seen occurring with loans out there, given the significant influx of capital, especially on the institutional side. With significant allocations to private debt in the last 3 to 5 years, that money has to go somewhere and it's going into looser structures without covenants at higher leverage and most concerning with very aggressive adjustments.

So a big reason why our originations were down in the prior quarter on the new capital deployment side as we've been saying no to so many deals. In part, it's the underwriting aspects. And we have full-time people that do nothing but basically say no to adjustments on what comes pushed at us from Big 6 accounting firms and their [queue of ease]. And in part it's because of how we run our underwriting models, where base cases always assume a recession occurring within the investment horizon, say, a 5-year first lien senior secured loan; and on the earlier side of that 5 years now with our corporate expectation and underwriting.

So when you assume cyclicality of saying no to a lot of deals that others say yes to. And that's a challenge. With also challenges, we have significantly reduced our underwriting hold size from a risk management standpoint, so that means more deals to deploy similar dollars compared to before. We think that's a prudent risk management approach as well.

I'm encouraged by what we're seeing in the pipeline right now going forward, but it has meant net repayments in the last couple of quarters.

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [5]

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Matt, this is John. I like the question so much, I just mentally reviewed all 125 positions that we have. And I think the common theme, at least for me, is that each one depends far more on the abilities of management to run their companies efficiently to take advantage of opportunities. And that's how the middle market is, where typically, these smaller companies have a very large opportunity set. And if they execute on that, they will be less subject to macro developments. So that's an opportunity for us, but it's also a challenge because we do have to find and back the very best managers, which is, trust me, we're busy doing that. Thank you.

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Matthew Alan Tjaden, Raymond James & Associates, Inc., Research Division - Research Associate [6]

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That's very helpful. And then kind of a follow-up question related to that. Through the second half of 2019 as it relates to originations, are you seeing any spread widening?

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [7]

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A little bit. Well, you say through the second half. Through today, there's a little bit of a response, not quite symmetric with the spread tightening that occurred with an increase in LIBOR. It's not quite an asymmetric response with the spread widening with the decrease in LIBOR. And I think the reason for that is that influx of capital that I mentioned before that has to have a place to go. At least in the middle market and especially in the middle market, where capital can't disappear from the scene quite so quickly as it can on the larger side in the syndicated market where fund flows can reverse streams and where capital can actually exit, and then you have essentially foreselling through redemptions that can cause the gap out in spreads. So we actually see that more on the larger side of things, and we cover both bases directly and indirectly through our structured credit business.

So in the middle market, a little bit. I would say we're spending a lot more time on lower middle market and smaller credit situations than before. In part, it's because of what I mentioned before about reducing hold size. In part it's because of our desire to have covenants in agented deals. And in part, it's because of lessened competition and improved spreads. So it really depends on the segment. I would say that, that middle portion in between the lower middle market and the broadly syndicated is stubbornly not showing an increase in spreads that you might hope to see at this point of the Fed cycle.

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Matthew Alan Tjaden, Raymond James & Associates, Inc., Research Division - Research Associate [8]

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Okay. And then kind of a shift away from rates, specifically on InterDent, so a $60 million markdown on the term loan C. Just given the large relative size of the investment, any guidance you all are willing to provide on the asset?

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [9]

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Well, just to give a little bit of color on that with -- InterDent's a dental services company, highly recurring revenue business. The fundamental demand is not in question, given it's basically a teeth-cleaning and recurring service. One part of the business is a fee-for-services, largely private pay business; and the other is a Medicaid-centric business based in Oregon.

There was a downtick in volumes in Oregon because of contracting activity in the last year. Now there's a new set of contracting activity occurring. We're cautiously optimistic we're going to pick up some portion, it's not clear how much, of the lost volumes. The business has also been focused on rightsizing its cost structure. There have been some labor cost increases because of the tightening employment market, especially within health care and the dental part of health care. So the business is adjusting to that as well. I'd say we're cautiously optimistic about seeing improved performance as we head into 2020.

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Matthew Alan Tjaden, Raymond James & Associates, Inc., Research Division - Research Associate [10]

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Great. And then kind of similar to that question, $20 million markdown about on the equity of Valley Electric, any guidance as to that asset?

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [11]

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Yes. That's really more of -- less to do with how the business is performing. The company is doing terrifically well. Recall, this is a business that's in electrical infrastructure-focused services company in the Pacific Northwest, largely in Washington state and benefiting from the technology boom of that state that used to be driven by Microsoft years ago and is still a major infrastructure employer, but also, of course, Amazon and many other technology-based companies. So the Seattle area and other parts of Washington state are doing quite well, growing infrastructure in the corporate side, which translates into the governmental side, industrial, health care, et cetera, corporate office side, real estate, all of which Valley benefits from.

So the company is doing well, there's basically a change in valuation inputs that get refreshed every quarter based on comps, based on comparable trading multiples, M&A multiples, et cetera. So you saw basically an adjustment there based on inputs. But we're quite pleased with the company and how the management team has been performing there.

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Operator [12]

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

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John Francis Barry, Prospect Capital Corporation - Chairman & CEO [13]

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Well, I could wax poetic, but I bet everybody wants to get to lunch. So thank you very much. Bye now.

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Michael Grier Eliasek, Prospect Capital Corporation - President, COO & Director [14]

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Thank you, all.

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Operator [15]

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