How This New Regulation Will Boost Prospect Capital Corporation's Business

Regulators are clamping down on banks, leaving other companies such as like Prospect Capital (PSEC -0.05%) to gain market share in leveraged finance. 

Recently, the Office of the Comptroller of the Currency and the Federal Reserve imposed a limit that would require banks to sit out on highly leveraged lending. Motley Fool Financials Bureau Chief David Hanson and Fool contributor Jordan Wathen interviewed Grier Eliasek, president and COO of Prospect Capital, to ask how those regulations are impacting the levered loan business for business development companies. 

A transcript follows the video.

Hanson: Great. Moving to a little bit of a different topic, and new regulations that are affecting buyout leverage, and the limits on that, how is Prospect being affected by regulation from the OCC, from the Fed, that aims to hold buyout debt leverage at less than six times EBITDA?

Eliasek: Prospect and other nonbank lenders, including other BDCs, stand to benefit significantly from increasing bank regulation in our country. The bank restrictions are even tighter than what you just quoted, when you get to the private capital middle market in which we compete.

In the middle market, banks must demonstrate to the regulators that their cash flow term loans pay off a certain amount of principal over a five-year period. Such regulation acts to limit leverage from banks to only around three times EBITDA for many companies.

Many middle market companies need more leverage than that for change of control, growth, and recapitalization financing, which creates an opportunity for Prospect to step in to compete, given that we do not take deposits, unlike a bank.

Our favorite way to pursue such business is with a first-lien senior-secured loan, with scheduled amortization, cash sweeps, and deleveraging financial covenants that get us paid down over the life of the loan, thereby reducing our risk. We're generally able to charge several hundred basis points higher than banks, because of our enhanced financial flexibility.

Hanson: Great. Jordan, any follow-up on that?

Jordan Wathen: I was curious, within those limitations, do you see banks competing more aggressively for the lower-levered stuff? Do you see the higher-levered deals going through CLOs? Where are those higher-levered deals flowing to -- the ones that the banks can't touch? Is it pure BDCs? Where are they going?

Eliasek: It depends on which market you're talking about. If you're talking about the private capital market, the middle market in which we compete, the higher-levered deals are going in one of two directions.

One, the bank will provide a first-lien instrument, and a nonbank will provide some type of second-lien or junior debt/mezzanine instrument in a so-called "bifurcated" structure.

Wathen: Right. It's bifurcated, so the bank is taking the lesser-levered first lien, and everything after that goes ... it might be a unitranche deal or something like that, past that, except for that one sliver at the top.

Eliasek: That would be a bifurcated deal.

The second approach would be a so-called unitranche or one-stop deal, in which the bank does not provide any term debt, and all of the term debt is supplied by a nonbank like Prospect. That's in the middle market.

The six times leverage limit that you were quoting before is really more of a broadly syndicated issue on whether or not arrangers of large, broadly syndicated deals are subject to a cap as to how much leverage a company can have. Above six times, there can be an issue for that arranger and their regulator.

That's really not the market in which we tend to compete. That's the market that CLOs play in. We participate in CLOs indirectly in the equity business, but when I'm just talking about our straight lending business, it's the middle market aspects that I talked about that apply.