Prospect Capital - Q2 2024

Transcript

Operator (participant)

Good day and welcome to the Prospect Capital second quarter fiscal year 2024 earnings release and conference call. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by 0. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then 1 on a touch-tone phone. To withdraw your question, please press star then 2. Please note, this event is being recorded. I would now like to hand the conference over to Mr. John Barry, Chairman and CEO. Please go ahead.

John F. Barry III (Chairman and CEO)

Thank you, Betsy. 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 (CFO)

Thank you, John. This call contains forward-looking statements that are intended to be subject to Safe Harbor protection. Future results are highly likely to vary materially. We do not undertake to update our forward-looking statements. For additional disclosure, see our earnings press release in 10-Q filed previously and available on our website, prospectstreet.com. Now I'll turn the call back over to John.

John F. Barry III (Chairman and CEO)

Thank you, Kristin. In the December quarter, our net investment income, or NII, was $96.9 million, or $0.24, per common share. Our NAV stood at $3.68 billion, or $8.92, per common share, down $0.33 from the prior quarter. Since inception in 2004, Prospect has invested $20.6 billion across 420 investments, exiting 287 of those investments. In the December quarter, our net debt-to-equity ratio was 46.2%, down 27.9 percentage points from March 2020 and down 0.3 percentage points from the September 2023 quarter as we continue to run an under-leveraged balance sheet, which has been the case for us over multiple quarters and years. We have no plans to increase our actual drawn debt leverage beyond our historical target of 0.7-0.85 debt-to-equity, and we are currently significantly below such range. 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 78th, 79th, and 80th consecutive $0.06 per share cash distribution. Consistent with past practice, we plan on announcing our next share of shareholder distributions in May. Since our IPO nearly 20 years ago through our April 2024 distribution at the current share count, we will have distributed $20.76 per common share to original shareholders, aggregating approximately $4.2 billion in cumulative distributions to all common shareholders. Thank you. I will now turn the call over to Grier.

M. Grier Eliasek (President and COO)

Thank you, John. Our scale platform with $8.9 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 nearly 150 professionals, which represents 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-sponsored 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 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. 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. Consistent with our investment strategy, our secured lending and first-lien mix has continued to increase.

As of December, our portfolio at fair value comprised 58.7% first lien debt, up 1.4% from the prior quarter, 15.5% second lien debt, down 0.4% from the prior quarter, 7.9% subordinated structured notes with underlying secured first lien collateral, down 0.2% from the prior quarter, and 17.8% unsecured debt and equity investments, down 0.8% from the prior quarter, resulting in 82.1% of our investments being assets with underlying secured debt benefiting from borrower pledge collateral. That's up 0.8% 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 12.3% as of December 2023, a decrease of 0.4 percentage points from the prior quarter. Our interest income in the December quarter was 92.3% of total investment income, reflecting a strong recurring revenue profile to our business.

We also hold equity positions in certain investments that can act as yield enhancers or capital gains contributors as those positions generate distributions. We've continued to prioritize senior and secured debt with our originations to protect against downside risk while achieving above-market yields through credit selection discipline and a differentiated origination approach. As of December, we held 126 portfolio companies, a decrease of two from the prior quarter, with a fair value of $7.6 billion, a decrease of approximately $105 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 17.8%. As of December, our asset concentration in the energy industry stood at 1.4%, hotel/restaurant/leisure sector 0.2%, and retail industry 0.3%.

Non-accruals, as a percentage of total assets, stood at approximately 0.2% in December, no change from the prior quarter. Weighted average middle-market portfolio net leverage was 5.4x EBITDA, substantially below our reporting peers, and our weighted average EBITDA per portfolio company was $110 million. Originations in the December quarter aggregated $171 million. We also received $131 million of repayments, sales, and exits as a validation of our capital preservation objective, resulting in net originations of over $40 million as we continue to take a cautious approach toward new credit underwriting given macroeconomic conditions. During the December quarter, our originations comprised 53.8% middle-market lending, 30.2% real estate, 10.5% middle-market lending and buyouts, and 5.5% subordinated structured notes investments. 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 in-place and largely fixed-rate multi-year financing.

To date, on a cumulative basis, we've invested in $3.8 billion in 108 properties, including 3 triple net lease, 81 multifamily, 8 student housing, 12 self-storage, and 4 senior living. In the current higher financing cost environment, which has recently started to abate a bit, our new investment focus includes preferred equity structures with significant third-party capital support underneath our investment attachment points. NPRC or private REIT has real estate properties that have benefited over the last several years from rising rents, showing the inflation-hedged nature of this business segment, solid occupancies, high collections, work-from-home tailwinds, high-returning value-added renovation programs, and attractive financing recapitalizations, resulting in an increase over time 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've received back more than our capital invested from distributions and recapitalizations, has exited completely 46 properties at an average net realized IRR to NPRC of 25.2%, average realized net multiple of invested capital of 2.5x, and 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 $601 million across 33 non-recourse subordinated structured notes investments. We've focused on amortizing our subordinated structured notes portfolio while electing to grow our other investment strategies.

As a result, the structured notes portfolio now comprises less than 8% of our investment portfolio and is expected to decrease over time. These underlying structured credit portfolios comprise nearly 1,600 loans. In the December 2023 quarter, this portfolio generated a GAAP yield of 5.8%, down 4.9% from the prior quarter, and a cash yield of 20%, up 2.5% from the prior quarter. The difference represents amortization of our cost basis that returns capital to Prospect that we intend on utilizing for other investment strategies and corporate purposes. As of December, our current subordinated structured credit portfolio has generated $1.45 billion in cumulative cash distributions to us, representing over 118% of our original investment. Through December, we've also exited 15 investments with an average realized IRR of 12% and cash-on-cash multiple of 1.3x.

So far in the current March quarter across our overall business, we've booked $63 million in originations and experienced $22 million of repayments for approximately $41 million of net originations. Our originations have consisted of 62.3% middle-market lending and 37.7% real estate. Thank you. I'll now turn the call over to Kristin. Kristin?

Kristin Van Dask (CFO)

Thanks, Grier. We believe our prudent leverage, diversified access to matched-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 28 years into the future. Our total unfunded eligible commitments to portfolio companies totals approximately $28 million, representing approximately 0.4% of our assets. Our combined balance sheet cash and undrawn revolving credit facility commitments currently stand at approximately $1.02 billion. 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 under a bond and equity ATM, acquire another BDC, issue a listed perpetual preferred, undertake a preferred program, 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 December 2023, we held approximately $4.7 billion of our assets as unencumbered assets, representing approximately 60% of our portfolio. The remaining assets are pledged to Prospect Capital Funding, a non-recourse SPV. We currently have $1.95 billion of commitments from 53 banks, demonstrating strong support of our company from the lender community with a diversity unmatched by any other company in our industry. Shortly after the well-publicized bank failures in March 2023, 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-rating from S&P, an investment-grade Baa3 rating from Moody's, an investment-grade BBB-rating from Kroll, an investment-grade BBB-rating from Egan-Jones, and an investment-grade BBB-low rating from DBRS. We currently have 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 28 years. Our debt maturities extend through 2052.

With so many banks and debt investors across so many unsecured and non-recourse debt tranches, we've substantially reduced our counterparty risk over the years. In the December 2023 quarter, we have continued utilizing our revolving credit and have continued with our weekly programmatic equity issuance on an efficient funding basis. To date, we have raised over $1.7 billion in aggregate issuance of our perpetual preferred stock across our preferred programs and listed preferred, including $66.5 million in the December 2023 quarter and $11.7 million to date in the March 2024 quarter. During the December 2023 quarter, we commenced a tender offer to purchase for cash any and all of 5,882,351 shares of outstanding 5.35% perpetual preferred stock, resulting in 631,194 shares validly tendered at a price of $15.88, plus accrued and unpaid dividends for a total consideration of $16 per share.

We have four separate unsecured debt issuances aggregating $1.2 billion, not including our program notes, with maturities extending through October 2028. As of December 2023, we had $391 million of program notes outstanding with staggered maturities through March 2052. At December 31, 2023, our weighted average cost of unsecured debt financing was 4.15%, an increase of 0.07% from September 30, 2023, and a decrease of 0.18% from December 31, 2022. Now I'll turn the call back over to John.

John F. Barry III (Chairman and CEO)

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

Kristin Van Dask (CFO)

We will now begin the question and answer session. To ask a question, you may press * then 1 on your touch-tone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press * then 2. At this time, we will pause momentarily to assemble our roster. The first question today comes from Finian O'Shea with Wells Fargo. Please go ahead.

Finian O'Shea (Director and Senior Equity Research Analyst)

Hi. Good morning, everybody. Thanks for having me on. First question on the preferred stock, you've been buying down the Series A. Should we anticipate you exercising the issuer optional conversion feature when those Series A preferreds are ultimately out of the way?

M. Grier Eliasek (President and COO)

Hi, Finian. Thanks for your question. I'm not sure what you mean by buying down the Series A. I don't think we've been doing that. But we have no plans to exercise such option. We actually can't exercise such option for another 2.5 years because of an undertaking related to our listed preferred. But we have no plans to do so anyway. And actually, moving the other direction, we just launched a new series that's not convertible at all into common stock. So we actually are moving the other direction.

Finian O'Shea (Director and Senior Equity Research Analyst)

Okay. Appreciate that. And just to follow up on the REIT, it looks like you sold a property there this quarter. I hope I didn't get this one wrong as well. But curious, given the market environment, the headlines we all read, how that exit shook out, any color you can give on the IRR you experienced, what you sold versus your mark, what the cap rate you sold at was, would really appreciate color there? And that's all for me. Thank you.

M. Grier Eliasek (President and COO)

Sure. Thanks. The asset we sold was an asset in the student lending, sorry, student housing portfolio. Student housing book is actually performing quite well. And there is significant buyer interest in that segment of the real estate market. So we're happy to have diversification in our real estate portfolio. I know we sold it close to our mark. I don't have the IRR at our fingertips, but I know it was well into the double digits. Overall, within real estate, our book is doing quite well. Recall, we focus on workforce housing, multifamily. We don't invest in office. We don't invest in retail. These are the areas that have been most deeply impacted, of course, within real estate, sort of on the wrong side of the digital divide, if you will. We're on the right side of the digital divide. Folks need a place to live.

Multifamily has benefited significantly from problems and affordability issues in the single-family housing market, keeping people in their apartments. We actually see less turnover, and folks want to and need to stay in their apartments for a lot longer. We also have a greater mixed exposure into markets like the Midwest, for example, and selected Mid-Atlantic, Northeast markets that have had less supply additions compared to the Western states. Certain markets in the Southeast, places like Nashville and Austin, for example, have had huge surges of supply. We've declined to purchase any properties in those areas because of supply concerns. Even in those markets with additional supply, when you look at the forward pipeline past 2024, it sort of falls off a cliff. Most folks in the industry expect absorption to occur and, over the long term, for significant positive rent growth to continue from there.

We're very happy to have our real estate book, and it's performing well.

Finian O'Shea (Director and Senior Equity Research Analyst)

Awesome. Thank you, Grier. And I was just thinking if I'm able to sneak in a third topic we've touched on over the years, of course, which has been sort of running off the CLO book. Just wondering, with the sort of resurgence and resets and refis starting to build up, is there any? Are you compelled to pursue that kind of strategy, kind of rebuild the CLO book, extend these out, or should we still view them as runoff or such? And that's all for me. Thank you.

M. Grier Eliasek (President and COO)

Sure. So what we do with our CLO book is really no different than what we do with any of our positions on an ongoing basis, including real estate, including middle-market lending, including middle-market buyouts. When we examine a range of options for an investment, we're looking always at the NPV, the net present value of each potential option. And we're desiring, of course, to select the highest NPV option. With CLOs, the range of options for an existing investment, and it is an actively managed book, includes calling an investment. And we get the benefit of having call premium optionality as majority holder in our book here. That's number one. Number two, refinancing one or more tranches of the liability stack. We're pursuing that in one of our deals, for example. Number three would be, as you referenced, extending or resetting a deal.

Number 4 would be selling a position on a secondary basis. We're constantly looking at all 4 of those options. Our desire is not a one-size-fits-all sort of tops down, but rather bottoms up. It is a diversified portfolio of over 30 positions. What's appropriate for one deal may not be appropriate for another deal. In general, expect for that book to be a lesser percentage of our portfolio over time as other strategies grow and the overall balance sheet grows. We've got a very under-leveraged balance sheet with a lot of dry powder. On a dollar basis, I would expect for it to decline over time as well. We've got significant amortization occurring. It is true in the last couple of years because of where liability spreads have been, activity for refinancings and extensions have been somewhat muted.

In the current environment, as you pointed out, liability spreads are starting to tighten up. So there is some more optionality there. And it wouldn't be out of the question to do a refinancing and still continue to amortize at a higher NPV or do an extension and still sell. So these aren't mutually exclusive exits for us. But over time, I mean, this book at one point was almost 20% of our portfolio. And now it's in the 7%. It's declined substantially. And I would expect for that to continue.

Finian O'Shea (Director and Senior Equity Research Analyst)

Thanks, Greer.

M. Grier Eliasek (President and COO)

Thank you, Finian.

Kristin Van Dask (CFO)

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

Robert Dodd (Managing Director and Senior Equity Analyst)

Good morning. You just answered my CLO question. So the only other one I had was, on the allocation to Prospect Administration, it spiked up this quarter. Is that a new normal, or was there any one-time expense embedded in that? I mean, maybe related to the preferred tender or whatever. Can you give us any color on that? I mean, it was like $10 million sequentially.

M. Grier Eliasek (President and COO)

Sure. Thank you for your question. It's not the new normal. We should expect a lesser number, probably more in the 5 range per quarter going forward, Robert. What you saw there was a couple of things. One, comping it to the past, from time to time, we will have a contra expense that will happily reduce that number. We had a significant litigation settlement in our favor in the past, which reduced that number associated with assisting one of our portfolio companies. And then there's some sort of a catch-up allocation on top of that. But the answer is no. That's not the new normal. And we should expect more in the range of $5 million per quarter.

Robert Dodd (Managing Director and Senior Equity Analyst)

Got it. I appreciate it. Thank you.

M. Grier Eliasek (President and COO)

Thank you, Robert.

Kristin Van Dask (CFO)

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

John F. Barry III (Chairman and CEO)

Well, thank you, everyone. Have a wonderful day. We'll see you in 90 days. Thanks, all. Bye.

M. Grier Eliasek (President and COO)

Thank you.

Kristin Van Dask (CFO)

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