Prospect Capital Corporation (NASDAQ:PSEC) Q2 2023 Earnings Call Transcript

Prospect Capital Corporation (NASDAQ:PSEC) Q2 2023 Earnings Call Transcript February 10, 2023

Operator: Welcome to the Prospect Capital Second Fiscal Quarter Earnings Release and Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Mr. John Barry, Chairman and CEO. Please go ahead.

John Barry: Thank you, Sara. Good morning, everyone. 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 press release and 10-Q 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 December quarter our net investment income, or NII was $106.7 million, or basic NII of $0.23 per common share, exceeding our distribution rate per common share by $0.05. Our basic NII coverage of our common distribution is now 128%. Our annualized basic NII yield is 9.3% on a booked basis and 12.3% based on our February 7 stock close. Our basic net income applicable to common stockholders was $55.6 million or $0.14 per common share. Our NAV stood at $9.94 per common share in December, down $0.07 and 0.7% from the prior quarter, largely due to unrealized mark-to-market depreciation from macro conditions. Over the 11 quarters from the pre-pandemic December 2019 quarter to the September 2022 quarter, Prospect delivered the highest growth in the business development company industry in net asset value per common share, with NAV per common share increasing by 15.6% over that time period.

Since inception in 2004, Prospect has invested $19.9 billion across 407 investments, exiting 275 of these investments. We have outperformed our peers during past periods of macro volatility as a direct result of our previous derisking, not chasing leverage, as well as other risk management controls, including avoidance of cyclical industries and utilization of longer dated flexible financing. We are staying true to the strategy that has served us well since 1988, controlling and reducing portfolio and balance sheet risk, both to protect the capital entrusted to us and to protect the ability of such capital to generate earnings for our shareholders. In the December quarter, our net debt-to-equity ratio was 49.4%, down 24.7 percentage points from March 2020, and down 4.1 percentage points from the September 2022 quarter, as we continue to run an underleveraged balance sheet, which has been the case for us over multiple quarters and years.

Over the past five years, other BDCs have increased leverage, with a typical list of BDC now at 117% debt to total equity, or approximately 67 percentage points higher than for Prospect. 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. In May 2020, we moved our minimum 1940 Act’s regulatory asset coverage to 150%, equivalent to 200% debt to equity, which not only increased our cushion, but also gave us flexibility to pursue our subsequently announced junior capital perpetual preferred equity issuance, which counts towards 40 Act asset coverage, but which gets significant equity treatment by our rating agencies.

We have no plans to increase our actual drawn debt leverage beyond our historical target of 0.7 to 0.85 debt to equity, and we are currently significantly below such target range. Prospect’s balance sheet is highly differentiated from peers with 100% of our debt funding coming from unsecured and nonrecourse debt, the case for Prospect for at least 15 years. Unsecured debt was 71.3% of our total debt in December 2022 or 23 percentage points higher than 48% for the typical listed BDC. Our unsecured and diversified funding profile provides us with significantly lower risk and significantly more investment strategy and balance sheet flexibility than many of our BDC peers. 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 February, March and April. These three months represent the 66th, 67th, and 68th consecutive $0.06 per share cash distributions. Consistent with past practice, we plan on announcing our next set of shareholder distributions in May. Our goal over the long term is to sustain shareholder distributions, providing stability against a macro backdrop, delivering greater volatility elsewhere. Since our IPO 19 years ago, through our April 2023 distribution, at the current share count, we will have paid $20.04 per common share to original shareholders, representing two times December common NAV and aggregating over $3.87 billion in cumulative distributions to all common shareholders.

Since October 2017, our NII per common share, less preferred dividends, has aggregated $4.20, while our common shareholder distributions per common share have aggregated $3.78 with our NII exceeding distributions during this period by $0.42 per share and representing 111% coverage. We are also pleased to announce continued preferred shareholder distributions following successful launches of our $1.75 billion non-traded preferred programs, and $150 million listed preferred. We’ve raised approximately $1.4 billion in preferred stock to date with strong support from institutional investors, RIAs and broker dealers, including the addition of two top five sized independent broker-dealer systems as well as top wirehouse and regional broker-dealer systems.

We’re currently focused on multiple initiatives to enhance our NII, return on equity and NAV in an accretive fashion including; first, our $1.75 billion perpetual preferred equity programs, which could potentially be increased in capacity in an accretive fashion. Two, a greater utilization of our cost-efficient revolving credit facility with an incremental cost of approximately 5.91% at today’s one month SOFR. Three, increase of short-term LIBOR and SOFR rates based on Fed tightening boosting asset yields. And four, increased primary and secondary originations of senior secured debt and selected equity investments to deliver targeted risk-adjusted yields and total returns as we deploy available capital from our current underleveraged balance sheet.

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 as we have. Prospect’s management is the largest shareholder in Prospect and has never sold a share. Our senior management team and employees happily eat our own cooking, currently owning approximately 28% of shares outstanding, representing approximately $1.1 billion of our common equity as measured at net asset value. Thank you. I will now turn the call over to Grier Eliasek.

Grier Eliasek: Thank you, John. Our scale platform, with approximately $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 100 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. 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 have maintained and continued to maintain significant dry powder that we expect will enable us to capitalize on such attractive opportunities as they arise. This 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 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, our portfolio at fair value comprised 53% first lien debt, up 1.2% from the prior quarter, 18.5% second lien debt, down 0.5% from the prior quarter, 9% subordinated structured notes with underlying secured first lien collateral, down 0.2% from the prior quarter and 19.5% unsecured debt and equity investments, down 0.5% from the prior quarter, resulting in 80.5% of our investments being assets with underlying secured debt benefiting from borrower-pledged collateral.

That number up 0.5% from the prior quarter. Prospect’s approach is one that generates attractive risk-adjusted yields. In our performing interest-bearing investments, we’re generating an annualized yield of 12.9% as of December, an increase of 0.5 percentage points from the prior quarter and a significant contributor to NII growth this past 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 December, we held 130 portfolio companies, an increase of two from the prior quarter with a fair value of $7.8 billion, an increase of approximately $188 million.

We also continue 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 17.7%. As of December, our asset concentration in the energy industry stood at 1.6%. Our concentration in the hotel, restaurant and leisure sector stood at 0.3%, and our concentration in the retail industry stood at 0.4%. Nonaccruals, as a percentage of total assets, stood at approximately 0.5% in December, up 0.2% from the prior quarter and down 0.4% from June of 2020. Our weighted average middle-market portfolio net leverage stood at 5.4 times EBITDA, substantially below our reporting peers. Our weighted average EBITDA per portfolio company stood at $112 million.

Originations in the December quarter aggregated $308 million. We also experienced $77 million of repayments and exits as a validation of our capital preservation objective, resulting in net originations of $231 million. During the December quarter, our originations comprised 86.6% middle-market lending, 8.5% real estate, 3.5% middle-market lending and buyouts and 1.4% 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, we’ve acquired $3.8 billion in 105 properties across multifamily, 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 structures with significant third-party capital support underneath our investment attachment point. 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 December, and not including partially exited deals, where we received back more than our capital invested from distributions and recapitalization, has exited completely 45 properties at an average net realized internal rate of return 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 December, we held $699 million across 37 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 10% of our investment portfolio. These underlying structured credit portfolios comprise around 1,700 loans and a total asset base of around $15 billion.

In the December quarter, this portfolio generated an annualized cash yield of 11.6% and GAAP yield of 14.9%. That’s up 1.7% from the prior quarter, with the difference representing a significant amortization of our cost basis. As of December, our subordinated structured credit portfolio has generated $1.47 billion in cumulative cash distributions to us, representing around 108% of our original investment. Through December, we’ve also exited 11 investments, with an average realized internal rate of return of 15.2%, and cash-on-cash multiple of 1.44 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 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 32 refinancings and resets since December 2017. So far in the current March 2023 quarter, across our overall business, we booked $26 million in originations and experienced $40 million of repayments for $15 million of net repayments.

Our originations have consisted of 51.1% middle-market lending and 48.9% real estate. Thank you. I’ll now turn the call over to Kristin. Kristin?

Q&A Session

Kristin Van Dask: Thank you, 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 non-controlled portfolio companies totals approximately $84 million, representing approximately 1.1% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stands at over $1 billion.

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 December 2022, we held over $5.2 billion of our assets as unencumbered assets, representing over 66% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, a nonrecourse SPV, where in September 2022, we completed an upsizing and extension of our revolver to a refreshed five-year maturity.

We currently have $1.7 billion of commitments from 49 banks, an increase of seven 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. 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%. Of our floating rate assets, 94.1% have LIBOR or SOFR floors with a weighted average floor of 1.20%. Short-term rates have now exceeded these floors, giving us the benefit of increased asset yields from Fed rate hikes. 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 in 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, an 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 have 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 counterparty risk over the years.

In the December 2022 quarter, we have continued utilizing our low cost revolving credit with an incremental 5.91% cost. We also have continued with our weekly programmatic InterNotes issuance on an efficient funding basis. To date, we have raised approximately $1.4 billion in aggregate issuance of our perpetual preferred stock across our preferred programs and listed preferred, including $298 million in the December 2022 quarter and $70 million to date in the current March 2023 quarter, with the ability potentially to upsize such programs based on significant balance sheet capacity. We now have six separate unsecured debt issuances aggregating $1.5 billion not including our program notes, with maturities extending through October 2028. As at December 2022, we had $350 million of program notes outstanding with staggered maturities through March 2052.

At December 31, 2022, our weighted average cost of unsecured debt financing was 4.33%, remaining constant from September 30, 2022, and a decrease of 0.06% from December 31, 2021. 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 price per share of $25.

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

John Barry: Kristin, thank you very much. And Grier, thank you very much. We can now answer any questions.

Operator:

John Barry: Well, thank you, everyone. Have a wonderful morning and afternoon. Thanks all. See you next time. Bye now.

Grier Eliasek: Thank you.

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