Prospect Capital Corporation (NASDAQ:PSEC) Q4 2023 Results Conference Call August 30, 2023 11:00 AM ET

Company Participants

John Barry - Chairman and CEO
Grier Eliasek - President and COO
Kristin Van Dask - CFO

Conference Call Participants

Finian O’Shea - Wells Fargo
Robert Dodd - Raymond James

Operator

Hello and welcome to Prospect Capital’s Fourth Quarter Fiscal Year 2023 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.

John Barry

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

Kristin Van Dask

Thanks, John. This call is the property of Prospect. Unauthorized use is prohibited. This call contains forward-looking statements that are intended to be subject to safe harbor protection. Actual developments and results are highly likely to vary materially, and we do not undertake to update our forward-looking statements unless required by law. For additional disclosure, see our earnings release filed previously and available on our website, prospectstreet.com.

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

John Barry

Thank you, Kristin.

In the June quarter, our net investment income, or NII, was $112.8 million or basic NII of $0.23 per common share, exceeding our distribution rate per common share by $0.05. Our basic net investment income coverage of our common distribution is now 128%. Our annualized basic NII yield is 10% on a book basis and 15.3% based on our August 25th stock price close.

Our NAV stood at $9.24 per common share in June, down $0.24 or 2.5% from the prior quarter, largely due to unrealized mark-to-market depreciation.

On the cash shareholder distribution front, we are pleased to report the Board’s declaration of continued steady monthly distributions. We are announcing monthly cash common shareholder distributions of $0.06 per share for each of September and October. These two months represent the 73rd and 74th consecutive $0.06 per share cash distributions. Consistent with past practice, we plan on announcing our next set of shareholder distributions in November.

Since October 2017, our NII per common share less preferred dividends has aggregated $4.63, while our common shareholder distributions per common share have aggregated $4.14, with our NII exceeding distributions during this period by $0.49 per share and representing 112% coverage.

Thank you. I’ll now turn the call over to Grier.

Grier Eliasek

Thank you, John.

Our scale platform with over $8.8 billion of assets and undrawn credit at Prospect Capital Corporation continues to deliver solid performance in the current dynamic environment. Our experienced team consists of over 130 professionals, representing one of the largest middle-market investment groups in the industry. With our scale, longevity, experience and deep bench, we continue to focus on a diversified investment strategy that spans third-party private equity sponsor-related lending, direct non-sponsor lending, Prospect sponsored operating and financial buyouts, structured credit, and real estate yield investing.

Since inception in 2004, Prospect has invested $20.2 billion across 418 investments, exiting 279 of those investments. Consistent with past cycles, we expect during the next downturn to see an increase in secondary opportunities, coupled with wider spread primary opportunities with a pullback from other investment groups, particularly highly leveraged ones. Unlike many other groups, we maintained and continue to maintain significant dry powder and balance sheet flexibility that we expect will enable us to capitalize on such attractive opportunities as they arise.

Over the past five years, other BDCs have increased leverage with a typical listed BDC now at 124% debt to total equity or approximately 75 percentage points higher than for Prospects, running at less than half the debt leverage of the rest of the industry, Prospect has not increased debt leverage, instead electing lower risk from lower debt leverage with a cautious approach given macro dynamics. Our diversity of origination approaches 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 invest 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. Consistent with our investment strategy, our secured lending and first lien mix has continued to increase. As of June 2023, our portfolio at fair value comprised 56.5% first lien debt, that’s up 2.1% from the prior quarter; 16.4%, second lien debt, that’s down 1.2% from the prior quarter; 8.6% subordinated structured notes with underlying secured first lien collateral, down 0.6% from the prior quarter; and 18.5% unsecured debt and equity investments, down 0.3% from the prior quarter, resulting in 81.5% of our investments being assets with underlying secured debt benefiting from borrower pledged collateral. That’s up 0.3% from the prior quarter.

Prospect’s approach is one that generates attractive risk-adjusted yields. And our performing interest-bearing investments were generating an annualized yield of 13.3% as of June. That’s an increase of 0.1 percentage points in the prior quarter as we continue to benefit from increases in short-term rates. 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 also achieving above-market yields through credit selection discipline and a differentiated origination approach.

As of June, we held 130 portfolio companies, which is an increase of 3 from the prior quarter at a fair value of $7.7 billion, an increase of approximately $132 million. We also continued to invest in a diversified fashion across many different portfolio company industries with a preference for avoiding cyclicality and with no significant industry concentration. The largest is 18.6%.

As of June, our asset concentration in the energy industry stood at 1.6%; in the hotel, restaurant and leisure sector, 0.3%; and the retail industry, 0.3%. Nonaccruals as a percentage of total assets stood at approximately 1.1% in June, up 0.9% from the prior quarter. Our weighted average middle-market portfolio net leverage stood at 5.2 times EBITDA, substantially below our reporting peers. Our weighted average EBITDA per portfolio company stood at $113 million.

Originations in the June quarter aggregated $372 million. We also experienced $122 million of repayments, sales and exits, further validating our capital preservation objective and resulting in net originations of $250 million, as we continue to take a cautious approach toward new credit underwriting given macroeconomic conditions. During the June quarter, our originations comprised 69% middle-market lending, 18% real estate, 10.2% middle-market lending and buyouts, and 2.7% structured notes.

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, and in the past year, an expansion into senior living, with attractive in-place 5- to 12-year financing. To date, on a cumulative basis, we’ve acquired nearly $4 billion in 105 properties across multifamily, which are 81 properties, student housing 8 properties, self storage 12 properties, and senior living 4 properties. In the current higher financing cost environment, we’re focusing on preferred equity structures with significant third-party capital support underneath our investment attachment points.

NPRC, our private REIT, has real estate properties that have benefited over the last several years and more recently from rising rents, showing the inflation hedge nature of this business segment, strong occupancies, high collections, suburban work-from-home dynamics, 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 as of June, and not including partially exited deals where we have received back more than our capital invested from distributions and recapitalization, has exited completely 45 properties at an average net realized IRR to NPRC of 25.2%, an average realized cash multiple of invested capital of 2.5 times, with an objective to redeploy capital into new property acquisitions, including with repeat property manager relationships.

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 favorable risk-adjusted opportunities. As of June, we held $665 million across 35 nonrecourse subordinated structured notes investments. We’ve maintained a relatively static size for our subordinated structured notes portfolio on a dollar basis, electing to grow our other investment strategies and resulting in the structured notes portfolio now comprising less than 9% of our investment portfolio.

These underlying structured credit portfolios comprise more than 1,600 loans. In the June quarter, this portfolio generated a GAAP yield of 12.8%, down 1% from the prior quarter. As of June, our current subordinated structured credit portfolio has generated $1.5 billion in cumulative cash distributions to us, representing approximately 113% of our original investment. Through June, we’ve also exited 13 investments with an average realized IRR of 14% and cash-on-cash multiple of 1.4 times. 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 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.

We’ve completed 32 refinancings and resets since December of 2017, over six years ago. So far in the current September 2023 quarter, across our overall business, we booked $53 million in originations and experienced $59 million of repayments and sales for about $6 million of net repayments and sales. Our originations have consisted of 59% real estate and 41% middle-market lending.

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

Kristin Van Dask

Thanks, Grier. We believe our prudent leverage, diversified access to match book funding, substantial majority of unencumbered assets, weighting toward unsecured fixed rate debt, avoidance of unfunded asset commitments and lack of near-term maturities 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 29 years into the future.

Our total unfunded eligible commitments to portfolio companies totals approximately $48 million, representing approximately 0.6% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stand at over $983 million.

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 and equity ATM, acquire another BDC and many other lists of firsts. In 2020, we also added our programmatic perpetual preferred issuance to that list of firsts, followed in 2021 by our listed perpetual preferred as another first in the industry.

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 June 2023, we held approximately $4.8 billion of our assets as unencumbered assets, representing approximately 61% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, a nonrecourse SPV where in September 2022, we completed an upsizing, an extension of our revolver to a refreshed five-year maturity.

We currently have $1.93 billion of commitments from 53 banks, an increase of 11 lenders from August 2022 and demonstrating strong support of our company from the lender community with the diversity unmatched by any other company in our industry. Shortly after the well-publicized bank failures in March, we added two new banks and upsized an existing bank within our credit facility. The facility revolves until September 2026, followed by a year of amortization with interest distributions continuing to be allowed to us. Our drawn pricing is now SOFR plus 2.05%.

Outside of our revolver and benefiting from our unencumbered assets, we’ve issued at Prospect Capital Corporation, including in the past few 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 minus rating from S&P, an investment-grade Baa3 rating from Moody’s, an investment-grade BBB minus rating from Kroll and investment-grade BBB rating from Egan-Jones and an investment-grade BBB low rating from DBRS. In 2021, we received the latter investment-grade rating, taking us to 5 investment-grade ratings, more than any other company in our industry. All of these ratings have stable outlooks.

We’ve now tapped the unsecured term debt market on multiple occasions to ladder our maturities and to extend our liability duration out 29 years. Our debt maturities extend through 2052. With so many banks and debt investors across so many unsecured and nonrecourse debt tranches, we have substantially reduced our counter party risk over the years. In the June 2023 quarter, we have continued utilizing our revolving credit and have continued with our weekly programmatic InterNotes issuance on an efficient funding basis.

To date, we have raised over $1.6 billion in aggregate issuance of our perpetual preferred stock across our preferred programs and listed preferred, including $112 million in the June 2023 quarter and $52 million to date in the current September 2023 quarter, with the ability potentially to upsize such programs based on significant balance sheet capacity. We now have 5 separate unsecured debt issuances, aggregating $1.2 billion, not including our program notes, with maturities extending through October 2028.

As of June 2023, we had $358 million of program notes outstanding with staggered maturities through March 2052. At June 30, 2023, our weighted average cost of unsecured debt financing was 4.07%, remaining constant from March 31, 2023, and a decrease of 0.28% from June 30, 2022. In 2020, we added a shareholder loyalty benefit to our Dividend Reinvestment Plan, or DRIP, that allows for a 5% discount to the market price for DRIP participants. As many brokerage firms either do not make DRIPs automatic or have their own synthetic DRIPs with no such 5% discount benefit, we encourage any shareholder interested in DRIP participation to contact your broker. Make sure to specify you wish to participate in the Prospect Capital Corporation DRIP plan through DTC at a 5% discount and obtain confirmation of same from your broker. Our preferred holders can also elect to DRIP at a 5% discount to the stated value per share of $25.

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

John Barry

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

Question-and-Answer Session

Operator

[Operator Instructions] Today’s first question comes from Finian O’Shea with Wells Fargo. Please go ahead.

Finian O’Shea

Hey everyone. Good morning. Can you talk about the delay in the 10-K, if there was any difference between this year and last year’s? And also, can you give us a sort of plain English description of the control issue that the auditor has with the CLO valuation? Thank you.

Kristin Van Dask

Sure. I can try to take that question. Hi Finian. So, for this year, there is no issue or any other reason than we need additional time to finalize documentation. There’s just more paperwork to do, and we’re almost there. So, we don’t anticipate any issues or changes to our numbers in the earnings release, and we’re planning to file as quickly as possible. And as far -- we don’t expect any repeat issues or new issues, if that answers your question.

Finian O’Shea

The release does mention there’s still -- it’s in part the delay but also in part of the audit of the effectiveness of the Company’s internal control which I think you mentioned last year would expect to be settled. So, I guess, is there anything to see on that half of the statement?

Kristin Van Dask

Yes. I think we’re not done until we’re done, and everything is filed, but I think different than last year, we had no issues that we anticipate, and it’s just a matter of wrapping things up and getting filed is our current expectation.

Finian O’Shea

Okay. Thank you. And maybe a follow-up also on CLOs, but to Grier’s comments on the prospect for potential resets. What’s the sort of feel you have for your current CLO book on the potential to reset or extend? And also, what would your view be on, say, investing more equity capital into those vehicles to facilitate that? Thank you.

Grier Eliasek

Sure. CLO book for context is the smallest by far of our business segments, only about 8% of our book, not a significant economic driver at all anymore. It’s down maybe two-thirds from where it was the peak many years ago. In terms of resets within that small portfolio, it’s a spread tightening environment right now. The loan market has been relatively robust in the last few weeks and months. There is new issue occurring. Whenever we analyze a particular investment, and we’re well diversified and nonrecourse basis with 35 deals, it’s an NPV analysis that’s ongoing, really all the time related to whether or not we stay the course, with the status quo, whether or not we call a deal, or whether or not we refinance the deal, meaning change the liabilities without changing expected maturity or tenure. Then number four, whether or not we reset a deal.

So, our goal is to choose the highest NPV option that maximizes shareholder value in each case and that can vary. Obviously, there was an impact from the pandemic within structured credit and the loan space generally, that’s significantly abated over the last 18 months. The loan space has held up quite well as many folks know, given these are floating rate assets, yes, also floating rate liabilities within structured credit, but quite a different experience from the fixed rate bond market. But overall, we’d expect, as I mentioned in my prepared comments that this smallest portion of our business will continue to get smaller still.

Operator

The next question comes from Robert Dodd with Raymond James. Please go ahead.

Robert Dodd

Hi. Just first question, going back to the 10-K issue, I mean -- you need more time. I mean is the BDC likely to see an incremental increase in expenses? I mean, is the back office understaffed, is that why things are not getting done on time? Because again, this is the second year in a row. I mean what needs to change to get the data, the information et cetera process faster, so shareholders can get their filings on time?

Kristin Van Dask

Yes, sure. And John and Grier, I can take a stab at this question. I can assure you, our plan is not to have an increase in expenses and extensions going forward. There’s really been a dramatic increase in the audit documentation driven from the PCOB requirements, and I think that’s what we’re struggling with -- not struggling with, but handling this year, there’s just a lot of additional work and documentation that is taking us a little bit past the deadline. And so, we are already strategizing on how to handle that going forward to make sure our filings are on time and keep our expenses at a minimum.

Robert Dodd

Got it. Thank you. On to credit quality, because obviously, we don’t have the 10-K with all the details. I mean, nonaccruals ticked up a little bit or not much at 1.1%. The unrealized depreciation in the non-control book, not the lead, et cetera, was the largest part. Can you give us any color on what the largest drivers of the nonaccrual increase in the markdowns were? I mean my guess is PTX. Can you give us any color on what’s going on the marginal credit side?

Grier Eliasek

I’ll take that, Robert. Thank you. Your estimate is spot on. It is one company, but for -- we would have had an evaluation increase for the quarter.

Robert Dodd

And then last one, on overall, obviously, rates are up, a fair number of your portfolio companies have fixed rates rather than floating, but still you’ve got floating rate exposure. What proportion of your portfolio companies right now don’t have the cash flow to pay their cash interest? And then, how are you dealing with that, whether it’s a sponsor relationship or where you are the sponsor in some cases, if that’s -- there are instances of that?

Grier Eliasek

A couple of items. First, over 94% of our portfolio is floating rate assets. So, we have benefited from rates going up with an uptick in net investment income for the quarter as well. Number two, we actually just completed an exercise spot on with what you were asking about. Only about 2% of our middle-market lending book has, over the last fiscal year sub 1.0 fixed charge coverage, which, of course, is due to rates going up. And of course, those companies are pulling levers, as you would imagine, to correct that through cost cutting and business growth initiatives.

We’ve also done stressing as to what would happen to that 2% number, if rates were to go up another 25 bps and another 50 bps. And I found that that 2% number for the fiscal year doesn’t change. So, we’re very happy with the overall performance of our book. And I think it reflects how we originally underwrote these deals, assuming a degradation in cash flow. That’s just a lender glass half-empty type perspective that is protective when it comes to keeping the leverage low. We disclosed at our -- despite having $113 million of average EBITDA, which is much larger than any other middle-market lending portfolios, our attachment point is about 5.2x, which is significantly below the peers that report leverage, not very many peers report leverage, by the way, we do, and a few others do, maybe you can encourage peers to do so. But we’re below others, even though our EBITDA is higher. And as we know, in credit, all other things being equal, bigger is better. And you certainly saw that during the pandemic when larger credits were more resilient, and you see that during downturns in general.

But overall, I’d say our portfolio is holding up quite well amidst the increase in rates. We do have a portion of our portfolio that has not benefited as much from an increased rate. That’s a structured credit book. That’s the real estate book. That’s deals we also own equity, which, of course, becomes zero-sum with leverage. Folks, I’m hearing now are concerned about what about rates go down? Because inflation has abated or recession comes into play. And I would say, while we may not have gone up as much as others that have a 100% pure floating rate credit book, we will not go down as much as others, and have just a less volatile business model all weather in nature compared to others vis-à-vis rate exposure.

Robert Dodd

I appreciate that color. Thank you, Grier. And I also agree with you, more timely disclosure from BDCs would be a good thing in general. Thank you.

Grier Eliasek

Thanks.

Operator

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

John Barry

Okay, everyone. Thank you. And we’ll see you on the next call. Have a wonderful day now. Bye.

Grier Eliasek

Thank you all.

Operator

Conference has now concluded. Thank you for your participation. You may now disconnect your lines.