Deep Value Investor Tim Melvin recently had the opportunity to speak with Michael Cimini from Prospect Capital Corporation PSEC about his company, the industry and what the future might hold.
Tim Melvin: We're on today with Michael Cimini, the head of investor relations at one of my, to be honest, all-time favorite companies; that's Prospect Energy. Michael, thanks for taking the time out and rushing out of your kid's recital this morning to be with us.
Michael Cimini: Pleasure to be here. Thanks for having me.
What's In A Name?
Melvin: Prospect Energy is a company I'm real familiar with. We were just talking before we came on that I actually sold shares in your IPO back in 2005 as a broker, but a lot of investors are not familiar with the business development company, or Prospect in particular. Can you tell us a little bit about the industry and exactly how this works?
Cimini: Sure, Tim. To start, the current name of our company is actually Prospect Capital Corporation. I think the mistake that you made is a common one, particularly now given concerns over energy exposure.
The Company
Cimini: We did go public in 2004 as Prospect Energy, but management had the tremendous foresight to know that in 2007 commodities were a little overheated, and so we made the strategic decision to significantly diversify our portfolio. We were nearly all energy related back in 2004, 2005, 2006 and even 2007, but fast forward to today and our portfolio is only 5 percent in energy-related investments.
It's a rather modest amount, particularly compared to where we were when we went public, as well as other BDCs. I think the average BDC has exposure of around 7 percent energy in their portfolios. I just want to make that clarification.
Melvin: I see.
Cimini: Go ahead.
Melvin: Us old guys are stubborn. I still refer to it as Prospect Energy these days.
Cimini: I would add that I don't think you're alone in that respect. I think there's a lingering perception that we're overweight in energy because people still know us from back in the day when we went public and before the great recession. That's how we were known and when the name Prospect comes up, I still think there's a small percentage of people that are out there that say, 'The energy company, right?'
But it's just simply not the case today. We have 140 portfolio companies today, well-diversified by both geography and industry. Our primary business is providing private, middle-market businesses with loans. Senior secured loans can be used as growth capital, refinancing acquisitions, recaps – you name it.
What Sets Prospect Capital Apart?
Cimini: I think the one thing that makes us a little bit different than others in our market is that we utilize our significant scale to take control of investments in companies and that obviously provides us with the ability to enhance total returns.
Spin-Offs Ahead?
Melvin: Right, now there has been some discussion of spinning off some parts of the company.
Cimini: Sure.
Melvin: Where are we on that?
Cimini: Well, we continue to focus on the registration statements for each of the three spinoffs, and that is something we announced on our last conference call in November.
We should have an update for investors when we report our earnings next week, but the idea is that the three businesses that we're seeking to spin off are our online lending business, our real estate business and our CLO business.
We think that each of those three businesses would fetch a higher multiple on a stand-alone basis as a tier play as opposed to being kept within the current BDC structure. That's the idea behind that in terms of unlocking value for our shareholders.
Melvin: Okay, and just so readers are clear what we're talking about, can you define middle-market companies for us? I mean, what size of businesses are we dealing with?
Cimini: Sure. We define middle market as companies with annual EBITDA ranging anywhere between $5 million to $150 million.
Melvin: Okay.
Cimini: It's a pretty wide range, granted. I would say the average for us is about $40 million in annual EBITDA.
Preferred Capital Structure
Melvin: Okay. When you're making these investments, where in the capital structure do you prefer to invest right now? I know that changes overtime with market and economic conditions, but (pause)
Cimini: Sure. I think we generate an attractive yield, just under 12 percent as of the last reporting period.
But having said that, we do not focus on taking on excessive risk. We'd like to be as high up on the capital structure as possible, and so along those lines, 75 percent of our portfolio is comprised of first and second lean loans, majority of which is first lean.
And just over the past twelve months, we've been really focused on first lean, 71 percent of our origination over the past twelve months have been first lean.
Prospect Capital's Diversification
Melvin: Okay. You diversify pretty well across industries, as you mentioned. How many different companies and industries are in the portfolio now?
Cimini: We have 140 portfolio companies right now. In terms of the number of industries, I'd say it's pretty well diversified – over 15 or 20 industries, perhaps.
Some of those are really broad, such as business services. That's our largest at around 10 percent, but that covers a lot of ground – a lot of sub-factors, obviously just within that one industry. We sleep very well at night knowing that we're very well-diversified from the industry concentration standpoint.
Downfalls Of Being In The Credit Business?
Melvin: Okay. Now, when you look at the portfolio, are you having any difficulties with non-performing loans or defaults or anything along these lines?
Cimini: Well, we're a credit business, so that's always top of mind for us. And we've been quite successful in maintaining a quality book.
Our non-accrual rate as of the last reporting period was 0.03 percent of total assets, which is very low. It is something that we're quite proud of, and I think it speaks to our rigorous due diligence and selection process.
We see up to 3,000 opportunities per year, but only about 2 percent actually make it to closing. So, that type of screening process allows us to pick what we believe are the best opportunities on a risk-adjusted basis.
Melvin: Okay. Now, Prospect, like most business development companies, does in fact borrow money to lend out at higher rates, and we profit from the spread. What happens if interest rates start to go up?
Cimini: We stand to benefit in a rising interest rate environment, and that's because we have well over 90 percent of our interest-bearing assets, our floating rate and approximately 87 percent of our liabilities fixed.
We're well positioned to benefit from an increase in interest rates. We do have floors of about 1 to 1.25 percent, so there probably wouldn't be much of an impact during the first 100 basis point movement.
But, we think that anything beyond that, we would expect to increase our earnings. Everything else being equal, of course.
The Search Is On
Melvin: Okay. Now, you're looking at 3,000 different opportunities, funding about 2 percent of them, where do you find your borrowers? How do you go about finding these businesses to lend to?
Cimini: We have various sources to originate or to drive investment activities. Obviously, we have strong relationships with various private equity firms. That's a key component.
And then we work with management teams both past and present, and they refer us business as well. We have our own call center, which is unique. I believe we're the only BDC that has its own call center, and they reach out to thousands of intermediaries with the focus on proprietary deal flow.
And so, we have multiple channels to help drive new business, and that's what drives our success in terms of seeing as many opportunities as we can. And then we do them all and pick out what we believe are the best ones.
'Skin In The Game'
Melvin: Okay. Now in the past years, the noted academic and investor Nassim Taleb has talked a lot about 'skin in the game,' and how officers and directors of a company that actually have their own money in the deal tend to improve performance and focus, let's say. Your executives have quite a bit of skin in the game, don't they?
Cimini: No doubt. I think we've being very active on that front of late. Taking it at these levels, management is sending a clear signal that they support the stock and have confidence in our future prospects.
Just since last November, management has purchased over six million shares in total. Including last year, it's over eleven million. I think that says a lot about where we believe the company's headed as well as the future prospects.
We think that we've aligned ourselves with shareholders along those lines and should increase the confidence of investors in general.
Recent Moves And Looking Ahead
Melvin: Okay. Now last month, you guys reduced your dividend a little bit and it looked like a prudent move to me to match up cash flows with dividend payouts, and your CEO John Barry said there's a possible upside to the dividend cut. Can you explain that to us?
Cimini: Yes. We believe that we've set the dividend to a level that we believe will be covered by net-investment income going forward, to the extent that we think there will be the potential for special dividends in the future.
Take a look at what we did last quarter. We did $0.28 in net-investment income and on a pro-forma basis that represents dividend coverage of about 112 percent. Just using that as an example, we think that the dividend is very safe in terms of where we have set it at, and we think that we will cover it with a high eye going forward and also provide shareholders with the opportunity to benefit from specials as well.
IPO Effects
Melvin: Okay. You guys went public, I thought it was 2005, it's actually 2004. How's the total return of performance to investors been since then?
Cimini: Since 2004, I'm not sure I have that number readily available, but I would say that over time, over a long term, we have outperformed the overall market.
I think our total returns since January '05 to September 30 of last year was 138 percent, and that is greater than the other major indices, as well as other BDC's that were public at the time.
Looking Ahead
Melvin: Okay. Now, a lot of folks I've talked to about business development companies think that there's a huge opportunity over the next several years, as banks continue to de-risk their portfolio. Do you have an opinion or thought on that force?
Cimini: I think there's no question that banks have certainly stepped away from middle-market lending, and that has created quite an opportunity for BDCs. I think it helps to explain the increase in the number of BDCs that have gone public over the past few years, because there is a tremendous opportunity, we feel, within the middle market, which is underserved.
The middle market is quite large; so, if you were to make the U.S. middle market its own separate country, it would be the fifth largest economy in the world. For such a huge, huge market to begin with – and then with banks stepping away due to the increased Lego toys environment (pause). They're focused on asset-base lending as opposed to casual-based lending. It has created quite an opportunity for BDCs like ours.
Final Thoughts
Melvin: Okay, any final thoughts on the industry and Prospect Capital that you'd like to share with our readers?
Cimini: Again, at these levels where we're trading at right now, at considerable discounts towards the NAV and combined with an attractive double digit yield, we think that our current level makes for an attractive entry point.
Over time, we believe that there's a significant opportunity for capital appreciation because historically, we have traded at a premium of two NAV. Just to get back to those types of historical levels combined with our current yield creates quite a compelling opportunity for investors who are in this space.
I would encourage them to check out our website and to learn a little bit more about our company at www.prospectstreet.com or call me with any questions you may have. My direct number is 212-792-2095. I always like taking the time to speak with prospective investors, as well as current shareholders, to tell them a little bit more about our company.
On behalf of Benzinga, thank you goes out to Michael Cimini for taking the time to grant Benzinga the opportunity to conduct this interview.
This article was a collaborative project between Tim Melvin and Benzinga's Anthony Sanfilippo.
© 2024 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.
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