Prospect Capital Corporation (PSEC) Q4 2007 Earnings Report, Transcript and Summary

Good day and welcome to the Prospect Capital fourth quarter and fiscal year 2007 earnings release and conference call. (Operator Instructions) It is now my pleasure to introduce your host, John Barry, Chairman and CEO. Thank you, Mr. Barry. You may begin.

Thank you, Joe. Joining me on the call today are Grier Eliasek, our President and Chief Operating Officer; and Bill Vastardis, our Chief Financial Officer. Before we begin, Bill will review a few legal matters.

Thanks, John. This call is the property of Prospect Capital Corporation. Unauthorized broadcast is prohibited. This call contains statements that constitute forward-looking statements within the meaning of the securities laws. All such forward-looking statements are intended to be subject to Safe Harbor protection. Actual outcomes and results could differ materially from those forecast due to the impact of many factors beyond the control of Prospect Capital. We do not undertake to update our forward-looking statements unless required by law. For additional disclosure, please look to our earnings press release and 10-K recently filed. Now I will turn the call back over to John.

Thanks, Bill. Our net investment income for the fourth fiscal quarter was $8.4 million, $0.42 per weighted average number of shares for the quarter, and a 19% increase over third fiscal quarter net investment income. Our net investment income for the fiscal year ended June 30 was $23.1 million, $1.47 per weighted average number of shares for the year, and 170% increase over prior year net investment income. At June 30, our net asset value per share was $15.04. We estimate that our net investment income for the current first fiscal quarter ended September 30th will be $0.41 to $0.45 per share. We have increased our September dividend to $0.3925 per share, our 12th consecutive quarterly dividend increase. Grier will comment on our investment activity.

Thanks, John. At the end of our fiscal year end, the fair value of our portfolio was approximately $328 million in 24 long-term investments, with the remainder in cash and short-term instruments. As of June 30, our portfolio generated a current yield of 17.1% across all our long-term debt and equity investments, including dividend, net profit interest, and royalty income. Excluding non-debt income, our weighted average long-term debt yield as of June 30 was 15.9%. Last quarter, we completed five new investments, which consisted of ESA, Ken-Tex Energy, R-V Industries, H&M Oil and Gas, and Regional Management Corp., as well as follow-on investments in the existing portfolio totaling approximately $130 million in the prior quarter. Additionally, on June 6th, Charlevoix Energy repaid its loan with a repayment penalty of approximately $400,000. We continue to maintain a net profit interest in Charlevoix. As previously disclosed, we received a 1.2 times cash-on-cash return and a 21% realized internal rate of return thus far on the Charlevoix investment. In the first quarter of our fiscal year, the current quarter just ended, we have closed on three new investments; Wind River, Deep Down, and Diamondback, totaling approximately $30 million. Additionally, on August 16th, Arctic, doing business as Cougar Pressure Control, repaid its loan with a repayment penalty of approximately $400,000. We continue to hold penny warrants in this investment. As previously disclosed, we received a 1.25 times cash-on-cash return and a 20% realized internal rate of return thus far on the Arctic investment. Also in August, ESA filed voluntarily for reorganization in response to a foreclosure action by us. Currently, we are reviewing several potential investment opportunities and have executed letters of intent with 11 companies, aggregating approximately $200 million of prospective investments. We continue to see a robust pipeline of other potential investments and the backlog continues to build. We are pleased with the volume, quality and diversification of our transaction flow, both within the energy industry and in additional sectors. Energy continues to be a core area of our focus and we continue to identify additional sectors to further diversify the portfolio. Many of our transactions to date have been situations where we provided financing to management teams who control the equity. While we continue to pursue that strategy, we are also increasingly looking at situations, either A, to provide financing to a third party, private equity financial sponsor, pursuing acquisitions and recapitalizations, either as the admin agent or on a syndicated loan basis, and including primary as well as secondary paper; or B, to target one-stop acquisitions where we have, as Prospect, control of the equity and also provide financing to the transaction. The credit dislocations in the overall market in July and August have had limited impact on our directly originated portfolio, but such dislocations have improved spreads and increased our interest in participating in the broader syndicated market. Thank you. I’ll now turn the call over to Bill.

Thanks, Grier. On June the 6th, we closed on a $200 million, three-year revolving credit facility with Rabobank as administrative agent and sole lead arranger. The interest on borrowing under the facility is charged at libor plus 125 basis points. Currently our borrowings aggregate approximately $60 million under the facility. Now I will turn the call back over to John.

Thank you, Bill. That concludes our prepared remarks. We can now answer any questions listeners may have.

(Operator Instructions) The first question is from Robert Dodd with Morgan Keegan. Please go ahead with your question.

Hi, guys, just two quick ones; on the guidance, that includes the Arctic $400,000 prepayment, penalty gain, whatever we want to call it -- any other non-recurring items that you’ve factored into there or one-off fees that you are expecting in the quarter that you can give us an idea about?

That is the only one-time income item for the quarter. There are -- the rest of the income is made up of the typical interest and dividends.

Okay, and then, can you just lead us down the credit quality of the portfolio? Obviously particularly still interested in the coal investments and then I guess the latest on what is going on with ESA?

Sure. In the case of the coal investments, we continue to carry unity at $10,000. There may be an opportunity there, given that the first lien has been either completely or almost completely paid off ahead of us and there are some efforts to use the equipment that’s there to perhaps restart a mining operation. I’m not holding out any hope but there at least is that possibility at the moment. Given that we carry it at $10,000, it’s not taking up a lot of our time but if there’s an opportunity, we’d like to look at it. With respect to Whymore, Whymore is making a mountain stake in I think about $100,000 a month and we would like to see that profitability increase. With the addition of Sid Young to our company there, we are seeing tightened procedures and more cash flow there, in addition to [DJ] Patent. At Genesis, we have to reconfigure our equipment to make that mine operate the way it should be operating, so we are going to be trading in some equipment and buying some additional equipment but believe that that mine will also be profitable, although at this point now it is still in the development stage, which for us means that it’s losing a little bit of money each month, which is offsetting the earnings at Whymore -- not quite. Whymore’s making more money than Genesis is losing. Genesis is losing maybe $30,000 to $50,000 a month, in that neighborhood, maybe $80,000 a month and Whymore’s making I think, you know, $100,000 to $120,000. We continue to look for additional acquisitions in coal country which, in Appalachia, is characterized by distress so there are now some higher quality operations that are available that we are hoping we can combine with what we’ve got. That’s those, those are the coal companies. WECO, which runs the power plant in Maine, continues to ramp up availability, continues to really clear out bottlenecks in the plant that were inherited from the 20 years or so of intermittent use. The main challenge is to get our wood price down and we are addressing that in two ways. We have market purchases of wood and we also have our own in-house wood harvesting company, which should enable us to harvest and burn wood at a price that doesn’t include the profit margin that any other business would have, so we continue to work on that and each week and each month, we continue to make progress. We are in a spot now where we can be paying interest but not all the interest every month, and amortization I think is still some months away. It’s moved more slowly than we would like but at least it’s been moving in the correct direction, which in these things is sometimes the best you can hope for. In the case of ESA, we were pretty disappointed that the management did not act as prudent stewards of the capital that was entrusted to them and in fact withdrew some of it to pay themselves in excess of what was agreed -- at least, that’s our position. We did not give up on the business. We moved to foreclose on the company on its valuable subsidiary, we think valuable, THS and on the assets available to us at ESA. The management then went and filed a voluntary petition in bankruptcy, which didn’t set up the bed of roses for them that they hoped it would because we took it all very seriously and we objected to that management team having any use of cash collateral. Anybody familiar with bankruptcy in this country knows that that’s a very low probability objection but we were quite organized and we prevailed. As a result, the bed of roses did not eventuate and the company was without the cash that it needed to operate, unless they could cut a deal with us. And the deal is that we are credit bidding our debt in the bankruptcy in order to buy the whole company and we have a management team there that we like. It’s actually one of the people that was there prior to this bankruptcy filing. We, rather than give up on the company and foreclose, I think we calculated it -- we could get -- I forget what it was, $0.30, $0.40 on the dollar by liquidating equipment and real estate and certificates of deposit. We felt that there’s significant enterprise value there and if we worked with the government, which is their primary customer, and we had a replacement person with all these nine A and disabled veteran certifications, that there’s a business there. And so we are proceeding on that basis. I think any day now, maybe today, our purchase of the business, for no new capital by us, will be confirmed by the court and we will then go on from there to collect receivables and to book new contracts and see if we can’t realize the enterprise value of that business. Fortunately, there’s a subsidiary there, a company called THS, that we now own 100% of and that business is on a run-rate right now of about $1.5 million of EBITDA. Now, if you gave that a fixed multiple, you’ve got $9 million right there of value. And if you were to look at the land and the other things at ESA, the parent company, and conclude that you’ve only got $2 million to $4 million, well, you’ve got $11 million to $13 million. Now, that’s getting close to full recovery. This of course will take a fair amount of work. Bob Everett, who joined us recently, has a lot of experience in these things and he’s doing a wonderful job so we are hopeful. We’re even hopeful that perhaps this THS company, which does outsourced arrangement of high compensation labor, doctors, surgeons, for the government and has a $9 million contract, can in fact grow faster than it did before ESA acquired the company. So lots of work there. It’s been a lot of work, it will be a lot of work. We continue to be hopeful that we can walk up the hill towards full recovery. At AOG, that company we funded unfortunately right before the Alberta gas market went into a tailspin. Grier mentioned to me that rig utilizations fell from 85% when we made the investment down to 15% now, as a result of a combination of factors, starting with lower gas prices up there, the inability to get it on to a pipeline because all the pipelines are filled, the overheated market, the lack of a hard winter to make the ground hard, and a number of other smaller factors, all of which really were harmful to AOG and, to a lesser extent, Iron Horse. What we’ve decided to do is bring in a chief restructuring officer, Mike Steele. He is optimistic that the company has a future with some refocusing, particularly on Northern Alberta, and at this point in time, we are examining whether we should merge with a company which has had a lot of success in Northern Alberta but is lacking the men and the equipment, and would like to combine with us and have us be in some respects the majority shareholder of the combined company, so we’re looking at that. Again, there I think we could have liquidated the company for maybe $0.40 on the dollar and we’ve concluded that the environment is distressed. There are opportunities there. We could take advantage of them and while we haven’t consummated or even concluded, we will go forward with anything there, we are working hard on it and once again, Bob Everett is in charge of that and he is flying up there, either tomorrow or Wednesday. So there’s the update on the companies that require enhanced care and feeding.

Robert, this is Bill again. In addition to the Arctic prepayment penalty, we also had structuring fee income on the three new deals during the quarter, which I would consider a one-time.

Got it. Thank you. I’ll hop back in the queue.

The next question is from James Bellessa with Davidson. Please go ahead with your question.

Good morning. In the prepared remarks, Grier talked about two new portfolio strategy approaches, an A and a B selection. Would you go over that a little more?

Sure, Jim, I’d be happy to. One of those approaches, B, which is pursuing acquisitions we provide financing, we’ve been doing already to date and those have been some of our best risk-adjusted, return-based transactions in the portfolio, including transactions such as Gas Solutions, NRG Manufacturing and R-V Industries, the three transactions which we purchase for an average EBITDA multiple of somewhere in the three to four range across those transactions, so needless to say we’d like to do more of that and we expect to be doing more of that going forward. The A piece I referred to was doing more business with financial sponsors, private equity firms who are acquiring companies or growing their existing portfolio of companies and are the majority equity owners of those businesses, as differentiated from sponsor-less transactions, many of which we’ve done to date, which do not have an institutional owner of the business and we are dealing directly with closely held, individually or family-owned companies, typically. We view the sponsor business as a lower risk business, as one where we can grow volume. It’s a business that comes with more pricing pressure, typically with sophisticated counter parties who are aware of various capital alternatives that are available to them in the market place. We’ve seen the activity in July and August in the financial markets shake out some of the marginal players from that marketplace, creating opportunities for us to participate as spreads have widened to much more attractive levels. So you’ll see us close more transactions in that arena, both on a primary as well as selectively on a secondary basis. You saw that activity in the last few months with our RMC transaction, for example, which was closed with two financial sponsors as co-owners of a business. Did that clarify things, Jim?

Yes, thank you, but how do you overcome the argument where in essence, your shareholders are paying a double management fee? You are paying your own management fee and then the financial sponsor’s management fee.

To clarify, we’re not investing in their funds. We’re not investing in the sponsor’s fund so there is no double layer of fees. We’re investing into a transaction where the sponsors are writing an equity check underneath us in the capital structure.

Okay, good. Thank you. I’m trying to track down the cash. You ended the March quarter at about $42 million in cash and then now you are saying at the end of September, you are down to about $60 million on your line of credit. And did I say March? I should have said June. June was about $42 million. I look at all the transactions and I’m coming up $12 million to $14 million short. Have you had some follow-on activities as well, follow-on investment activities in the last three months?

Yes. You had at the end of June, we said $41 million but there was $70 million in deals that had to be paid for. Did you factor that in?

I did, yes.

Okay.

And then the three deals in this quarter that you’ve called out and then one repayment, and I was coming up with $46 million, $47 million of negative, and that would have been the amount of your draw-down in your facility. But you’ve indicated in the press release today it was a $60 million draw-down.

Sixty-million is the correct number for the currently drawn facility, Jim.

Okay, so there could have been some other activities that are follow-on investments, is that the answer?

Yes.

In the income statement in the K, you have a footnote, footnote two about restructuring fee income and some other things that go into a pot called -- let me make sure I’m saying it -- other income, and then a sub-section of other income called non-control, non-affiliate investments. And that number hadn’t been hardly anything and then all of a sudden, it’s something and it looks like a material number, whereas some of your other line items are lower than previously. Can you explain what’s happening and what might happen in the future as a result of perhaps in the structuring fee incomes and other items that you called out?

Sure. Well, first of all, we break up all of the income items by the types of investments, control affiliated or non-control. In other income, as we say in that note, it includes structuring fee income, net profit interest, royalties, net yield deposits, and in particular a prepayment penalty on net profit interest. If you’ll recall during the year, Cypress was paid off. We had a net profit interest in Cypress, and that was a prepayment penalty of about $960,000 for foregoing the net profit interest. The major part of the increase in that particular category though is due to structuring fee income. Difference is up-front points, which are accretive over the life of the loan. Structuring fee income hits in the quarter in which we earn it and many of the recent deals have been done with structuring fee income rather than up-front points, so you’ve seen an increase in current income.

In the most recent quarter, the swing in interest income of your company went from almost $10 million down to below $8 million in the most recent quarter. Can you explain the decline there? That’s been, of course, offset by this improvement in this other category and is that a one-time drop in interest income or is that something that will continue at that level?

Which quarter are you referring to, Jim, the Q1 of 2008 or Q4 of 2007?

Fourth quarter of fiscal ’07, the interest income was $7.8 million. That compares to the previous quarter of almost $10 million.

Because in the previous quarter, Cypress also had a prepayment penalty of $1 million and that counts as interest income, the one-time hit in the previous quarter and then --

You just said that they also, instead of a prepayment penalty -- no, you say you had a -- in this footnote, it says prepayment penalty on closing net profits interest.

Right. Cypress we had a prepayment penalty on both parts of our deal. On the closing of the loan, they paid $1 million -- I think it was a little bit over $1 million in prepayment penalty for foregoing the loan. In addition, they paid us $960,000 for foregoing the net profit’s interest. The prepayment penalty that applies to the loan gets added to interest income, whereas the prepayment penalty for the net profit’s interest goes to other income.

And then in the explanation about ESA that John gave, you said that you are now owners of 100% of the THS, which I believe is The Healing Staff. But before saying that, you indicated that you examined what it would be if you liquidated the assets and you came up with 30% to 40% on the dollar, $0.30 to $0.40 on the dollar.

That would be just at the -- well, at the ESA level, we figured I think $2 million to $3 million for real estate, say $1 million to $2 million for accounts receivable, and then there’s a couple of CDs that are backing the bonding that I think maybe we thought about $1 million, $1 million to $2 million. So then you would add to that THS at $1.5 million times six times is $9 million. Then you might say well, I’m just going to discount all of this and get down to about $0.30, $0.40, maybe $0.50 on the dollar. And we concluded that we’d rather grow those values than really sit there and imagine what the liquidation scenario, any further what the liquidation scenario would look like.

And you just took them $1.5 million times a multiple of six, is that EBITDA or is that --

Well, you know, when you look at THS and they are earning $1.5 million and they do this with contracts that last into the months, and they are making $1.5 million, you can simply run off the contract and I forget if I ever knew exactly how much you would get from that contract. Or you can say the business has enterprise value and would somebody pay six times for a business like that with a potential for growth. Frankly, they would pay more except that you need to have all these certifications, so you can’t just sell it to just anybody. There are these mentoring and more complex relationships that go on in the government contracting market, so we just felt six times one-and-a-half is a fairly basic way to value a business like that.

And this became your ownership, even though they went into bankruptcy protection, all of a sudden you own this 100%?

Well, THS is not in chapter 11. THS is a subsidiary of ESA. The managers of ESA filed for protection in order to stop us from foreclosing on the THS stock and on the other assets of ESA.

And then on the Alberta Advantage Oil Field Group, you’ve indicated that you are working with somebody in Northern Alberta and you’ve sent up a restructuring officer up there. Have you taken over control of that whole entity?

No, no we haven’t. We are working in a friendly way with the management team, whom we like very much there, Chris Brunes and his brother runs Iron Horse. We feel we have a very good relationship, even though these things stress people out. Chris is actually the person who brought it to our attention, this other company that is interested in combining with Advantage and Advantage is interested in combining with them. We actually met the other company, came down into our offices a week ago and spent the afternoon with them. So we are taking it step by step. We are optimistic. It looks like it could be a good combination to me.

And to whom was the restructuring officer sent, to the Northern Alberta company or to the Advantage Oil Field Group?

Well, initially to the Advantage Oil Field Group. We made suggestions that hey, maybe somebody who has been through all these -- it’s a younger team at Advantage and we made some suggestions that maybe someone who’s been through all of the cycles could be helpful and Chris, to his credit, met with Mike Steele and said I like this guy. I think maybe I could learn a few things from him. Let’s see what he can do for us. And Mike is taking an interest, plus Mike Steele knows quite a few people and I think has been a good influence in the situation.

In regard to your dividend, you currently are paying or you just paid $0.3925, was it? Yes, $0.3925 and yet you’ve just reported a quarter that’s $0.42 and you are saying that the next quarter, the September quarter when you report should be in the same vicinity. You don’t want to reduce your dividend at some point in the future but you want to keep moving it up. What does this recent quarter activity, fourth quarter last year and this year’s first quarter, bode for the dividend?

Thank you for your question. We haven’t yet projected what the December dividend would be, nor as policy would do so this far ahead of making such a determination. You might ask why not bump up the dividend to a greater extent, giving the earnings that were declared. We want to be careful about that because of some of the one-time income factors previously mentioned, but we also wanted to catch up a little bit in our current tax year for tax efficiency planning purposes. We’re on actually an August tax year, so we wanted to catch up there and we’ll obviously look to see -- our goal, as we’ve disclosed previously, is to continue moving the dividend upward on a quarterly basis, not ahead of the business but consistent with how the business is performing and it is our intention to strive to meet that goal in every way.

Final question, you’ve indicated that you are drawing down $60 million of your line of credit, you are saying that your backlog of potential deals is at the level of about $200 million. Is there a timeframe that you could put on that and therefore give us an idea of when your next share offering would have to be to finance your next growth spurt?

Jim, it’s difficult to project. We have a robust pipeline, as we talked about and as you just pointed out. The pipeline to a certain extent, some of it can be drawn upon from a Rabobank perspective, from our credit facility. Some if it we may need to either syndicate or look to other means to close. There are various diversification buckets, cut-offs, et cetera that go into the Rabobank facility. I believe we filed that agreement in full with one of our more recent filings for the last 30 or 60 days, if I’m not mistaken. We have an effective shelf and we’ll continue to monitor capital needs in the coming weeks and months but as a matter of corporate policy, we don’t like to project the timing of potential future equity offerings.

Thank you very much.

The next question is from Henry Coffey with Ferris Baker Watts. Please state your question.

Good morning, everyone. I am looking at the ESA situation and remembering other situations that ultimately worked out very well for the company but caused a lot of anxiety with shareholders. I guess the only way to ask it is directly; what processes are in place or what new processes are in place to ensure that somehow the communication between you and your managers is solid and to make sure that you are investing with the kind of fiduciaries who won’t put you in this position?

I guess the first thing I would say about it, Henry, is that every day we find we can improve what we did the day before and so we are not bashful about saying that we’ve examined that situation very carefully and spent a fair amount of time reviewing internally, soul searching, you can call it, what were the things that we should have done that we didn’t do and what did we do that we shouldn’t have done? Now, I would like to announce that we’ve figured out how to never have this happen again. I can’t go that far. What I can say is that we have learned a number of things. One of the things that we’ve learned is that our early warning monitoring of these people and these systems is fairly intact in the sense that we were aware of what was going on and were communicating with the people and knew, so that this was not one of these situations where capital is fettered away and you only figure it out months later. That’s what I would call cold comfort; at least we were on top of this pretty quickly. The second thing we learned is that there is ultimately no guarantee against people feeding us information which either is incorrect or -- well, excuse me; which happens to be incorrect which they are feeding to us deliberately or which they are foolishly passing along to us in the belief that it is true. And recognizing that there is no absolute guarantee simply causes us to work harder, trying to minimize the percentage likelihood of that happening and the ability of people to do that and our level of discernment in the matter. So just to review ESA, for example, in the case of ESA, we had audits. We had audits from accounting firms that we talked to. We had a company called [Sherry Baker], which does a so-called quality of earnings review. We had a quality of earnings test from [Sherry Baker], in which they reviewed the audits and they did their own independent, third-party review. We of course had our lawyers review the contracting. We did our own due diligence. We reviewed the numbers. We spoke to customers and so we did many of the things that we do on every deal and in the case of this particular transaction, there were certainly complexities that were not wrestled all the way to the ground. One of the things we’ve decided we’d like to do is upgrade the level of people that do our quality of earnings assessments, and as a result we are much more likely to be using RSM McGladrey or another firm on a consistent basis, rather than using local firms. That’s going to increase our expenses but it seems to us to be a necessary step that we need to make. Number two, we are going to be a lot more careful of transactions in which management teams come to us with a growth capital story in a contracting business because what we find is that these contracting businesses, by their nature, are really the hardest to get your arms around with respect to percentage of completion, estimates of profitability. I think everybody on this call knows what I’m talking about and so the barrier for companies like that to get credit has certainly gone up. You might say a lot of people don’t do them. Well, people do do them and we have another one in here in our shop right now that Hicks Muse brought to us which is a very similar business. So people do do them. The experience you get in a sector, the bad experiences make you a lot smarter about them, needless to say. And the last thing we’re doing is we are putting a much bigger emphasis on having a large amount of capital underneath us, ideally from a sponsor, a professional buy-out firm. If not a professional buy-out firm, managerial capital underneath us because that is in effect in many ways the best insurance that we can have. Now, when our company was smaller and for diversification in [40 act] and subchapter M reasons, we had to do mostly very small deals. We didn’t have the luxury of being as demanding as we can be now.

What about the diversification effort? You’ve talked about -- I assume that the two investments you tag under the diversification profile are what, ESA and regional? Can you give us a sense of what other industries you’re looking at?

Well, we didn’t view ESA as necessarily a diversification outside of energy, because the construction that they do is, a significant portion of it is in fact energy. So I would say the first transaction we felt was a step away from the energy sector was the regional management investment, which is an investment in a lending company being purchased by two buy-out firms that we feel we know quite well. We hope to see others of that quality. I can say a few things about -- now that everyone’s on the phone, I can say a few things about the regional investment. It’s exceeding plan. It’s managed by very professional managers who have very professional reporting systems in place. We are very happy with that investment. We have a 1.7 cash-on-cash coverage of debt service. We have $54 million of equity underneath us. We have significant third-party consulting reports.

How much debt do you have above you?

The debt, Henry, is about exactly equal to the total debt that is pari passu, or ahead of us, it is equal to the gross assets of the company. I thought of about $80 million, right, Grier? Yes.

So you have $80 million -- I’m somewhat confused. You have $80 million worth of assets and then -- which I assume 75 of that is gross receivables, and then --

I think it’s actually about $80 million of gross receivables.

And what is the leverage -- excluding your investment, what is the debt against that $80 million?

I think it’s a Bank of America facility at libor plus whatever it is, 150, 175, something like that, and that is going to be, you know, 80 minus 25, I think it is $55 million, something like that.

And then you have your 25, so combined you equal 100% of the gross or the net assets, the net receivables?

Of the gross assets.

Of gross receivables?

Right, so --

And then underneath that is equity capital of?

Fifty-four million.

Now what other areas of diversification are you focused on? Obviously there must be -- I’m assuming that in your pipeline, you have some non-energy investments.

Grier is going to go through them individually. Just before he does, I wanted to tell you what the most important linkage for us is. It’s not whether or not we feel that we have the same level of expertise and experience that we have in oil and gas and in pipelines. While that’s important, as important, perhaps really more important is our estimate of the quality of the sponsor, the amount of equity capital underneath us, the professionalism of the due diligence. Because that is where we are looking to be able to leverage our relationships and grow the volume of our business. Grier will go through the individual items and he can highlight who the sponsors are in each case.

Well, rather than get into too much specificity, because there is some confidentiality at play --

That’s true.

I’d rather just give you some examples of some of the types of transactions we’re looking at in our pipeline beyond energy. I’d say, Henry, the bulk of what we are looking at right now is energy-related. Really the majority of what we’re looking at continues to be energy-related, but we are selectively in a highly bottoms-up fashion, on a deal-by-deal basis, looking at the merits of the transaction, the nature of the financial sponsor, which is really where we are looking for diversified type efforts. It doesn’t tend to be in the either prospect sponsored or prospects, a direct lending of thus far. It’s been primarily in the financial sponsoring. But we’ve been looking at the food products industry, for example, healthcare, sports equipment, the retail arts and crafts industry. There’s a number of areas that are interesting to us, primarily because we know both the firms as well as the individuals who are responsible for the control equity of those companies --

Is this -- the diversification, I mean, you’ve been -- you may disagree with this, but in many ways your success has been driven by your capacity to lend against pretty identifiable intangible assets, as well as tangible assets. Some would say hard money but I think your ultimate success has been driven by the fact that there’s been high levels of intangible assets that you could fall back on and -- is that part of the business model changed? Do you think by bringing in an equity sponsor, you can avoid some of the contentious situations you’ve gotten into in the past or is it the basic formula is still going to be a high return, high management, high touch investing style?

I would say we’ll continue to do both, Henry, and rather than say we’re not doing energy because we very much are, since --

No, no, I mean outside of the -- I mean, I think inside of the energy field, you’ve shown that that’s a viable approach.

Right, so it’s more kind of an energy plus approach. So the energy-related transactions are much more asset based types of transactions, with hydrocarbon, rolling stock, collateral, a lot of times we are senior secured, sometimes second lien. Sponsored transactions tend to be much more cash flow oriented but not always. For example, the regional transaction that John just went through and I know, Henry, you’ve got a lot of, many years of expertise in that particular part of the market, in alternative finance type of companies. We’ve got asset coverage through the second lien where our capital is, so we are looking to have secured debt, second lien type positions in those transactions with some type of asset coverage as well. I would say the risk mitigation is scale. They tend to be larger size companies with deeper management benches and with more diversified sources of revenue, as well as having an equity capital partner to be a first line of defense against fixing issues that might emerge. So we’ll continue doing both, Henry. I think one of the big benefits is that we’ll be able to get over time higher advance rates on our leverage. It’s difficult to get to a fully leveraged, one-to-one situation if you are only in four, five, six FIC codes and the ability to achieve high levels of leverage in advance rates, we view as a competitive advantage in this marketplace and one which we are quite intent upon achieving as we bit off some more diversity in the pool. I hope that answers your question, Henry.

Let me add a little -- Henry, let me give you a picture for just a second. These are lower risk transactions in which the var for us is higher, so we are looking at making an investment in a snack food company, where I think the agreement is a 14% all-in coupon and that’s it. Typically there’s no equity in these deals. The company has been in business since 1972 and as far back as we have numbers, which I think is 10 years, it’s every year better, more revenue and more operating earnings. Excellent management, so we don’t have equity. We get a 14% return, a large plug of equity underneath us. I think the loan is $18 million and it looks like a very solid and secure situation which is not going to earn us anything more than 14% but looks like the likelihood of a problem is significantly less than in some of these deals we have earned greater returns. So we think that that provides good balance in the portfolio. That company will be subject to different economic forces than other parts of the portfolio. We have, as I said, not only a great sponsor but we think a wonderful management team there. I like the idea of adding those deals to the portfolio on a one-at-a-time basis.

All right. Thank you.

The next question is from Greg Mason with A.G. Edwards. Please state your question.

Good morning, gentlemen. I just wanted to -- John, you talked about with the sponsor business, it seems like the sponsor is very key. Can you talk about how broad and deep are your sponsor relationships and how do you go about expanding that? And then the second question is, how does your underwriting change between a sponsored deal and a non-sponsored deal?

Well, I’ll speak a little bit for myself and I’ll mention everybody in our firm has sponsor relationships, given that we’re in New York. When I was an investment banker at Merrill Lynch, I called on sponsors and this company has been a sponsor for many years and has invested in other sponsor deals and had sponsors co-invest with us. Where I live in Greenwich, Connecticut, it seems like you need to be a sponsor to live there. I know quite a few and it turns out like this regional management deal, it happens to be from a firm called Palladium, where we know the people on a very personal basis and have for many years, and the Parallel guys, the same thing. So there’s a lot of that. We find that we are dealing with people that we know, which is an improvement over the energy business, where frankly a lot of the people that we are talking to are not people that we knew five years ago and that’s just the nature of the energy business -- smaller transactions, guys leave larger companies, they want to do something. There’s a little more risk dealing with people like that, obviously. So Grier, for example, he’s not a lawyer. He went to Harvard Business School. It seems that maybe a third of his class are working at sponsor firms, and that’s true of other people here. So we have no shortage of relationships with these sponsor firms and we are aware of their styles and their objectives and how careful we think they are and all of that feeds into our analysis. Does that answer that? Grier, anything you want to add?

Yes, just to add to that, Greg, thank you for your question. I would say in the sponsor business, one significant area of advantage we have over other lenders is that we have a significant direct origination platform. We originate somewhere in the order of 2,000 to 3,000 transactions per annum and as a result, we come to focus on the sponsor community, whether it’s people we already have relationships with or ones where we are seeking to develop relationships, with a number of good ideas on potential transactions, companies they can buy. You might say well, if you have such good ideas, why doesn’t Prospect go after them on your own? I would say they are ideas that require more financial muscle or scale relative to the size of our capital base currently, ideas that go beyond the yield orientation that we tend to have with our sponsored acquisitions. When you are buying businesses for three, four times cash flow, yes, you can generate plenty of current yields and have equity upside -- a lot harder when folks are chasing transactions into the seven, eight, nine, ten times world, as has occurred, especially for some larger deals. So we can share ideas that we think are attractive for folks that have more an event-driven type model in their investing as opposed to more of a yield orientation or total return orientation that we would have, plus we may do some type of equity co-invest anyways to capture part of the upside. You asked a question about underwriting criteria, Greg. I would say that for some of the energy related transactions, cash flow is an important consideration across all of our deals but it is more of a collateral and asset-based type approach, especially with hydrocarbon reservoir analysis types of transactions, and we tend to be much more senior secured there. In the sponsor arena, it’s much more of a, as I said to Henry Coffey at Ferris Baker just now, more of a cash flow approach but we don’t ignore asset coverage and collateral coverage either. In many cases, we can get some or all fully covered through the second lien, depending upon the transaction.

And what about actually doing due diligence? You’ve talked a lot in the past on your non-sponsored energy deals that you’ll go and kick the tires and make a lot of phone calls and try to find people that might have good and bad things to say about the company. Are you able to do that on a sponsored deal or do you just rely on the due diligence of the sponsor?

We do independent due diligence and verification in all cases, Greg, including if it’s a sponsor deal, in addition to what we would do for one of our “heaviest lifting” deals, which would be where we’re the sponsor, we’re lending into a closely held company situation. We’re not big believers in drafting behind other people’s due diligence, even if they are writing a significant check, and we reserve the right to ask lots of questions and do some of our own independent checking analysis. I would say the time to do due diligence is expedited because obviously others have asked similar questions and generated data which we can analyze to help us in our study in a sponsor situation, so the time can be shortened significantly in those types of transactions without sacrificing quality.

Great. Thank you, guys.

The next question is from Andrew Bowles with Prospect Capital. Please state your question.

Hello. I’m obviously not with Prospect Capital but -- I’m an individual investor down in Richmond, Virginia. I have a couple of questions. Regarding accruing interest income in non-performing loans, on the 10-K it states that less than one-tenth of 1% of the company’s net assets are in non-accrual status. How is that if funds such as to ESA and a manager are non-performing?

As of June 30th, there was only one non-performing loan, Unity, in the portfolio. At the time, ESA was paying interest.

Okay.

And in the current quarter, we’ve stopped accruing on ESA. The other dynamic that happens is we’ll tend to write down transactions in that category, Unity, for example, written down and ESA being written down as well, so that will cause that percentage to also adjust.

Just in case you’re not aware, Houlihan Lowkey values entire portfolio every quarter and so everything is written down or in some cases, written up to fair value on a quarterly basis.

Okay, there’s just a time lapse there.

We also just -- if one of our companies is doing very well, on the flip side, Andrew, and is generating a lot of earnings, for example, Energy Manufacturing, one of our portfolio companies, I believe has tripled its EBITDA in the past year, we don’t recognize more income by virtue of that unless they are giving Prospect Capital cash dividends, their enhanced dividends, along the way so it sort of cuts in both directions.

Right. To better understand the business in general, what is your share issue cost? Current data is $60 million right now on a short-term basis level, or plus whatever it is. And then, as that facility gets full, you’ll issue shares. What is the share issue cost generally?

Our credit facility cost, by the way, is libor plus 125 basis points, you just referred to, which we’re quite happy about and our Rabobank facility, down from in the 225 to 250 range from our prior credit facility, reflecting increased diversification and scale benefits there. Our share issuance cost, you are referring to when we go out and raise equity dollars?

Correct -- 6%, 5%, 4%?

We’ve been bringing that down over time. Our initial public offering years back was 7%, which seems to be the oligopolistic standard out there for IPOs, has come down. I think it’s all-on after that was around 5%, then 4.75% and it’s on a downward trend.

Regarding ESA, and sorry to set focus on the negative, because it looks like the performance there has been pretty strong, but regarding ESA and -- I’m reading about a $9 million loss, $0.45 on almost 20 million shares. Could Prospect have done anything better to value the assets that were backing up the loan as collateral?

I guess what I would say is that the loan was fully performing on June 30 and we’ve marked it down anyway. The second thing I would tell you is that there was a combination of circumstances that were moved very quickly and were somewhat surprising, starting with the bonding companies telling us before we closed that the bonds would stay in place after we closed, and then suddenly changing their minds which, for a government contractor, is very stressful, to say the least. So in the case of ESA, things actually moved pretty quickly in a negative direction, notwithstanding the company being -- performing and paying interest on June 30. That’s not to say that we could not always be more vigilant, more proactive, move more quickly, recognize problems earlier. We have early warning systems in. They work but they could certainly work better and we are always looking to improve them.

Regarding the write-downs and write-ups over the history of the company, is there anywhere to look where you can see, say the total write-downs and net asset value versus total write-ups of net asset value for the non-recurring or special income, either on a quarterly or yearly basis?

You can look in the quarterly table. Does that break it out? It’s on page -- it’s in the notes to the K, I believe. Is that combined? No, that’s realized and unrealized.

Well, one simple way to do it, Andrew, is when we went public, the NAV was $13.95. Now, it is $15.04, even though you are correct to point out it was $0.44 just relating to the ESA company. And in fact, Grier just showed me a note saying that on September 30th of ’04, the NAV was $13.74. We went public at $13.95, then we had costs before we made any investments, that drove us to $13.74, so we have added $1.50 of NAV to the company in the last year-and-a-half, even after you account for the companies that haven’t done as well as we would like. I would like to add that I’ve told people on this call in the past that this is a portfolio with risk in it. We don’t earn a 17% current return without accepting some level of risk. As time goes on -- and so having an ESA comes with the turf. Now, as time goes on, we believe that the risk in the portfolio and the return will both come down, which some people will like and some people may not like. We’d like to see the predictability of the portfolio grow and as a result, we may be seeing fewer of these 30%, 40%, 50%, 60% IRR equity investments and more, and also some where we lose capital, and more of these 14% sponsor deals that are fairly predictable.

Yes, I am sure it would be more pleasurable to answer questions about your successes than the problems, but that’s the nature of the call.

Well, I guess I would say that the whole investment universe thinks the way we do. When we get here in the morning, we don’t sit here and high-five about the companies that are doing well and then go out and have a beer. We sit here and we focus on the ones that we think could be working better and -- because we feel that that’s where our attention should be. The companies that are doing very well, they don’t need much input from us so like you, we focus on the companies that aren’t doing well. But sometimes we lose sight of the fact that the NAV has grown by $1.50 or more. The -- we have 12 consecutive dividend increases and this is in a competitive world where there are other private equity shops -- I mean, thousands, and where there are many, many other mezzanine providers, some of whom are not being as careful as we think we are. So over time though, we would like to think that we do get better at this.

Actually, on page 70 --

What was that? Oh, they have your answer, Andrew.

On page 70 of the K in note seven, you’ll see in the financial highlights the share appreciation or depreciation of our investments for each of the three years.

Page 70, note seven?

Note seven, correct.

Thank you. If I can have one more question about ESA, the compensation paid to the ESA principals that violated the covenant of your loan, how much was that?

It was, if I remember correctly, it was a few hundred thousand dollars less than a half-million. What I have to say is that their story, if that’s what we should call it -- I’m not really sure what we should call it -- was that they had loaned money to the company and that they had a right to pay it back, that the company had issued notes to them in exchange for cash that they had given to the company. This is not unheard of in these kinds of companies. And our position was that while we were sorting out this bonding problem, it was a very inappropriate time to repay these “loans”, and that there should have been more disclosure and more discussion of those distributions. And then those discussions were not terribly fruitful with these people. They didn’t seem to recognize the seriousness of that and so one thing led to another and we concluded we needed to foreclose.

That’s it for me. Thanks for taking my questions.

No problem. Thank you, Andrew.

At this time, I am showing no further questions in queue. I would like to turn the call back over to management.

Thank you very much. I think we are finished. Thanks, everyone.

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.