Prospect Capital Corporation (NASDAQ: PSEC) is one of the biggest BDCs in the country -- investing in everything from syndicated loans to airplanes. Understanding its many business lines can be a task in and of itself, but a recent interview helps investors understand the high-level investing activities of the company.
In the following video, Motley Fool Financials Bureau Chief David Hanson and contributor Jordan Wathen interview Grier Eliasek on the going-ons of Prospect Capital's many different business lines.
A full transcript follows.
David Hanson: Welcome, Fools, I'm David Hanson and I'm joined in the studio by Jordan Wathen, and on the phone by the President and COO of Prospect Capital, Grier Eliasek. Grier, thanks for joining us today.
Grier Eliasek: Thank you for hosting me today, David and Jordan.
Hanson: We're going to dive right into it. For our listeners, Prospect Capital is one of the largest BDCs out there.
Grier, our first question for you is, a lot of the BDCs, large and small, are predominantly lenders to private equity companies for buyouts, but Prospect is a little bit different. They have their hands in more areas.
Can you give us a really brief overview of your main focus areas, as a business, and also which one of those businesses you get most excited about, looking out into the future?
Eliasek: Sure. With our more than $7 billion capital base, Prospect Capital is the only multi-line business development company. We believe our diversified origination profile gives us access to more investment opportunities than any other BDC.
We review more than 4,000 opportunities per annum across our 100-person team, so we can afford to be disciplined in our credit selection, and we close less than 2% of the opportunities that we review.
Also, if a BDC just has a pure credit book, that BDC can only go in one direction -- down, through defaults. Because we own controlling interests in many of our companies, we also capture the upside if those companies perform well. Those investments generally require larger check sizes, and have higher personnel/staffing requirements, which allows us to box out our competitors and use our scale to our advantage.
We have nine origination strategies. The first is sponsor finance, or lending money to private equity-owned companies, which is our largest segment. We generate significant repeat business, given our 26-year history as a company, and we also win significant business because we can write $50 to $300 million checks per deal, which smaller BDCs do not have the capital base to do.
Next up is direct lending, or lending money to non-institutionally owned companies. We have an internal cost center that calls on thousands of intermediaries to source proprietary deals in this highly inefficient market segment.
The third is operating buyouts, where we purchase a controlling interest in a company, alongside management, and also generally provide all the term debts to that company. We've had terrific success with our exits here, including exiting gas solutions and NRG manufacturing. These are a couple of deals that we exited a couple of years back, making 68 times our initial investment.
Then we do financial buyouts, which is the same as operating buyouts, except we can purchase these lending businesses in a tax-efficient manner, through partnerships. We own multiple such companies today, and are generating over 18% yields from this strategy.
Then we also do CLO equity, also known as structured credit, where we purchase majority interests in pools of syndicated loans against large corporate credits, and then we obtain financing from the investing grade market. We're generating over 20% cash yields from that business.
We also do real estate, where we own multiple private REITs and focus on purchasing garden style apartment complexes, generally across the Southeast, at favorable cap rates and long-term financing.
We also do online direct lending, which is a significant growth market focused on both consumers and small businesses.
We do aircraft leasing with an emphasis on midlife aircraft leased by credit-worthy airlines around the globe.
Then finally, syndicated debt investing, where we act as a liquidity bid when credit markets retract. That's a fairly dormant business for us right now.
We're excited about many of these businesses. If I had to highlight one area, it might be structured credit -- our CLO equity business. Prospect is the largest investor in U.S. CLO equity on the planet, and our book is performing well. Defaults are near zero, our vintages are spread across multiple years, and we have partnerships with the leading collateral managers around the world.
We expect to continue to be a market leader in the years to come.
Hanson: The yield on the return that you're going to get in some of those areas is going to vary -- be higher in some, lower in others. Are some of those small parts of your business, where they may be great yields, but it's not really going to move the overall needle of the entire Prospect business?
Eliasek: Our straight lending businesses tend to be closer to a 10% yield, then our structured credit and financial buyouts and other buyouts tend to be in the higher teens; in some cases closer to 20%-plus. Weighted average is about 12.5%.
Some of those businesses, we have regulatory caps on. For example, as a BDC we're capped at no more than 30% of our assets in financial services types of companies -- structured credit and financial buyouts in the aggregate can't be more than 30% -- so the regulatory structure in which we live drives us toward having some of that diversity as well.
Wathen: You've talked a little bit about the finance companies, and buying those. I know one on your balance sheet is fairly large, at least in terms of your average portfolio company, First Tower. I was wondering, how do you think about that business, and how do you think about how it impacts the Prospect portfolio as a whole?
Eliasek: First Tower is definitely one of our larger investments, but it represents less than 5% of our diversified asset base. We love the tax efficiency of this business. If Tower were to go public on its own -- which it's certainly big enough to do -- Tower would need to be a taxpaying corporation. Under a BDC umbrella, on the other hand, Tower is a non-taxpayer.
This company is not a payday lender. It is an installment lender that focuses on making so-called "A loans" to consumers in several U.S. states. These loans are generally two-year, $2,000 sized loans.
Tower has been in business for about 30 years, with a consistent business model over that time. The CEO of the company, Frank Lee, owns 20% of the business, alongside us, which aligns incentives nicely.
We've been pleased with the stability of Tower's business, and expect it to continue to be a meaningful cash flow generator for our company in the years to come.
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 6x EBITDA?
Eliasek: Prospect and other non-bank 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 3x 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 non-bank 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 tem debt, and all of the term debt is supplied by a non-bank like Prospect. That's in the middle market.
The 6x 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 6x, 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.
Hanson: Yes, we've been talking about the debt portfolio and some of the companies in that portfolio, like First Tower. But you mentioned earlier that Prospect also takes equity positions in these companies that they're investing in, and that can be one of the ways that shareholders see upside in terms of net asset value increasing as the equity investments increase in value as well.
Prospect suspended their ATM share program for the time being, I would guess. Is it safe to say that growing the balance sheet with equity is kind of off the table, since shares are trading below that NAV now?
Eliasek: Well, that is safe to say. As we discussed on prior earnings calls, Prospect is not keen on issuing shares below NAV. We did not file a new ATM program, given where we are trading. We're currently at a discount to net asset value with an over 12% dividend yield.
We think the current trading has a lot to do with the rebalancing of the Russell equity indices. As some of your viewers might be aware, the Russell indices recently removed BDCs -- these are the broad-scale equity indices -- because of a nonsensical technical regulatory rule.
The overall stock market has been hitting record highs, but BDCs in the last several months have underperformed the market because of this Russell rebalancing. The good news is, the Russell rebalancing will be complete next Friday, June 27, which thereby removes this technical overhang, so many out there are arguing that now is an excellent entry point for BDCs like Prospect Capital.
Wathen: As we think about Prospect growing its balance sheet -- obviously, as a BDC, you have to raise equity capital to do so, or raise debt capital, but obviously that's limited to the regulatory limits.
I was thinking, as you're growing, how do you weigh the payoff between issuing new shares and investing in, say, lower-yielding assets -- so your future investments may be lower-yield than the investments that you have on the books now -- how do you weigh when to issue shares and when not to?
Eliasek: Well, it's pretty straightforward. We're not interested in issuing shares below net asset value. Above net asset value, we may look to issue shares, hopefully at as large a premium as possible, based on what we're seeing with demand for our capital in the private marketplace.
We have a focus, given our large team, proprietary deal flow, and diversified origination strategy, on -- and it sounds trite -- but we try to make money in every year of the economic cycle, instead of just some years.
In the current environment, we are turning down low-quality companies and over-leveraged capital structures, but we're still finding attractive opportunities. In the March quarter we put on the books about $1.4 billion in gross originations, which was a record total for us. We're pleased with that output, and even more pleased with the credit quality of our portfolio which, as of the last quarter, had delivered a low 0.3% cumulative default rate.
Remember that our loans are generally five years at inception but typically pay off in two to three years, so we aren't taking long-term risk as a lender. We are looking to rotate out of lower-yielding situations, including a senior loan initiative that we announced recently to sell lower-yielding loans off the balance sheet, into probably some type of managed account structure, that would allow us then to rotate into higher-yielding situations.
Those types of strategic decisions are how we're dealing with potential yield compression in the marketplace.
Wathen: Great. Also, this was I thought an interesting investment for a BDC; in the last year you have started doing some more peer-to-peer lending. You have done it for a few quarters, and I hadn't seen any new, large investments in your filings recently, so I was wondering what's the strategy there? Is peer-to-peer something you are still interested in, or something you're phasing out?
Eliasek: We're very excited about this business segment, which we refer to as "online lending," because "peer-to-peer" is a bit of a misnomer when an institution like ourselves gets involved.
Our strategy has been an organic one, so far. We've been focused on purchasing consumer loans through Prosper and Lending Club, as well as small business loans through On Deck. These third-party origination platforms often retain loans on their own balance sheets, or sell loans to third parties.
As a result, we're currently looking to build our own origination platform or platforms, which we hope will generate greater origination volumes, higher direct yields, and potential equity upside from valuation growth in the originator itself.
We think this industry will continue to grow rapidly in the years to come, and we are keenly interested in continuing to be a market leader. We're looking at levered prime consumer, unlevered near prime consumer, and unlevered small business loan returns, net of losses of 15-30% in the online industry. So, it's safe to say that we're keen on making a greater allocation to this segment.
Wathen: You mentioned equity returns coming out of the peer-to-peer lending?
Eliasek: Well, if you own an originator, you have an additional storehouse of value for the future. Lending Club's last private round I think was $3.8 billion. Maybe it'll go public later this year, maybe Prosper and On Deck a year later.
If we're going to be supplying loan capital to an originator, let's capture the potential equity upside from the originator itself.
Hanson: So you're interested in actually trying to build out a platform similar to the Prospers and the Lending Clubs of the world? Or are you saying invest in those platforms?
Eliasek: The former. We're interested in owning our own platform or platforms, probably emphasizing small business first. Small business tends to need less leverage, and fits more favorably into our regulatory baskets.
We can do consumer as well, but there's a few more constraints there as a BDC, so probably emphasizing and focusing on small business first.
Wathen: Then finally, just to round it out here with a quick question on deal structuring -- is there advantage to structuring these buyouts with more equity to generate capital gains, or is there advantage to structuring it with more debt?
I know historically you have structured a lot of these investments with more debt than equity, and I was just curious to hear your take on that.
Eliasek: When we buy a company in a one-stop manner, where we supply a majority of the equity and debt, our desire is to do so tax efficiently. We do not want to under-leverage these businesses to result in tax leakage for shareholders.
We also want to be prudent about how much we pay for these businesses, so we can continue to generate an attractive yield for our investors. Many of our buyouts have been completed at only around 5x cash flow, which is not much more than a lending multiple in today's market. Ideally, we therefor get the equity for free, or close to free, which gives us upside in the business.
From an investor measurement perspective, our observation is that public company investors strongly prefer recurring income streams to lumpy capital gains for their base return, so we expect to continue to structure our control deals in this manner.
If any of these companies should do tremendously well -- and we are evaluating multiple companies in our book today for potential exit -- we would of course also generate a tax efficient capital gain for our investors, so we like to have our cake and eat it, too.
Wathen: Right, so rather than have the portfolio company pay taxes, you can insert enough debt to where you take the income out through the debt, without having it come through the equity? You're saying you basically minimize taxes at the portfolio company level?
Eliasek: Correct. Also, we're able to pledge those types of loans to our credit facility, get to borrow against them; a number of benefits.
Key in all this is not to overpay for a company. If you overpay for a company, whatever amount of debt you might slap on it, if the company can't service the debt -- and that's pretty clean; we put companies on non-accrual if it can't pay its contracted obligations within 60 days -- there's really no way of getting around it.
If we stick to the rules of not overpaying the companies that we're buying, and not over levering the companies that we're lending money to, that we're not buying, then we're going to be in very good shape, indeed.
Hanson: I've got one more question for you, and then we'll finish up here. If you were investing in one soccer team to win the World Cup, what are you picking right now?
Eliasek: Well, I'm an American, right?
Hanson: That's the right answer!
Eliasek: I'm going to pick with my heart, rather than my head. Go Team U.S.A.!
Hanson: All right, that's what we like to hear. Grier, we really appreciate you taking the time to talk with us today -- really insightful stuff -- so thank you very much.
Eliasek: David and Jordan, I really appreciate your time and hospitality on this show. Terrific, thank you.
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