Prospect Capital: High Yield, But With Caveats

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Prospect Capital Corporation trades at a 40% discount to NAV with a near 14% yield, but market distrust stems from 17% PIK (payment in kind) interest income.Despite a diversified portfolio and strong ...

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Supatman/iStock via Getty Images Shares of private debt provider Prospect Capital Corporation (NASDAQ:PSEC) are trading at a 40% discount to net asset value (NAV) and provide a current yield of 13.6%. There appears to be a disconnect in pricing given certain metrics, but with 17% of its FY24 interest income derived from payment-in-kind interest, the market doesn’t trust its NAV figure. With investors calling for a share buyback program that would amount to a partial liquidation of the business development corporation, the recent insider buying by the CEO merited a deeper dive. An analysis/recommendation follows below. Seeking Alpha Company Overview Prospect Capital Corporation is a New York City-based business development company [BDC] that provides primarily private debt (and some private equity) to middle-market companies in the U.S. with a current portfolio of 117 investments. It is the largest multi-line BDC, boasting assets of $7.9 billion as of June 30, 2024, having entered into 423 investments since inception. Prospect was both founded as Prospect Street Energy Corporation and taken public in 2004, raising net proceeds of $97.0 million at $15 per share. It changed to its current moniker in 2007 concurrent to terminating its approach of investing at least 80% of its net assets in energy concerns. Shares of PSEC trade at around $5.25 a share, translating to an approximate market cap of $2.2 billion. February 2024 Company Presentation The company operates on a fiscal year (FY) ending June 30th. For the avoidance of doubt, the twelve-month period ending June 30, 2024, is FY24. Business Development Companies BDCs like Prospect typically elect to be treated as regulated investment companies for federal income tax purposes, allowing them to avoid U.S. federal taxes on all taxable income, provided that they distribute at least 90% of taxable income. Furthermore, BDCs must have gross asset coverage of 150% (or a 2:1 debt-to-equity ratio), which was changed in 2018 from 200% (1:1). This construct allows non-accredited investors access to the private debt market. Prospect’s funding sources are widespread and include publicly traded notes, preferred stock issuance, common stock issuance, and bank financing. Approach Prospect technically has no employees, with its assets run by Prospect Capital Management. The screening process for a prospect (no pun intended) to become a credit in the company’s portfolio is rigorous. Its investment professionals evaluate ~3,000 candidates annually, with private equity-sponsored businesses and other intermediaries providing a large source of credit prospects. That said, the capital management team also employs a dedicated cold-calling effort to leave no stone unturned. The funnel typically consists of concerns with annual revenues less than $750 million and enterprise values less than $1 billion. From that pool of ~3,000, the company structures 200 to 300 deals, of which 20 to 40 close in any given year, meaning less than a 2% book-to-look ratio. Those transactions predominantly include lending to middle-market concerns – many controlled by private equity sponsors – comprising 52% of the portfolio; lending to businesses and purchasing controlling interests in said businesses (19%); purchasing controlling equity positions and lending to real estate investment trusts (19%); and investing in subordinated structured credit (7%). Portfolio February 2024 Company Presentation With this approach, Prospect has a diversified portfolio of 117 investments across 35 industries with 81% first lien, secured, or underlying secured assets. Approximately 89% of investment income comes in the form of interest income, predominantly floating rate and typically with a Secured Overnight Financing Rate [SOFR] plus structure. Real estate, which has come into greater focus in the higher interest rate environment, consists of a wholly owned real estate investment trust [REIT] known as National Property REIT Corp. (“NPRC”). It holds 61 properties, including multifamily, student housing, and senior living. At a fair value of $1.49 billion, it is the largest single component of Prospect’s $7.72 billion investment portfolio. February 2024 Company Presentation Market Disconnect That portfolio generated a 12.1% annualized current yield across performing interest-bearing investments with net debt leverage of 0.45 and a NAV of $8.74 a share, featuring a tiny 0.3% of non-accrual (non-performing) loans – all as of June 30, 2024. With a monthly common dividend of $0.06 (for a current yield of 13.6%) that was seemingly easily covered by FY24 net investment income of $1.02 a share, there would appear to be a significant disconnect between that performance and Prospect’s September 6, 2024, closing share price of $5.28. However, there are many reasons for the 40% discount to NAV. First, there are many instances in its controlled investment portfolio (and a few in its uncontrolled portfolio) where Prospect isn’t collecting cash interest but rather payment-in-kind (“PIK”). The “interest” collected through PIKs totaled of $134.5 million in FY24, or 17% of the total. Even though this interest is structured, it generates skepticism and uncertainty among investors as to the company’s ‘real’ non-accrual rate. Next, its portfolio’s net realized and net change in unrealized gains (losses) in FY24 was a loss of $156.8 million after this line item registered a loss of $522.4 million in FY23, largely due to the Chapter 11 filing of credit PGX Holdings (FY23 and FY24 net losses including successor company: $314.0 million). The company also realized losses of $188.6 million in its structured loan portfolio over those two years. Owing to these and other write-offs, NAV has declined from a peak of $10.81 per share in 3QFY22 to $8.74 per share, its lowest level since 1QFY21. Also included in the losses are $164.4 million (unrealized) from NPRC over the past two years. During the same period, Prospect has raised its debt investment into the REIT by $467.4 million. Although these gross additions can be in the form of loans for new portfolio properties, original issue discount accretion and PIK interest, it has some market participants, including research and investment firm Hedgeye Risk Management, suggesting that the company is filling in the cash flow deficit at NPRC via term loans. In February 2024, Hedgeye stated that the REIT had “not acquired a new property in 7 quarters, over which time PSEC sends over ~$250 million of term loan draws to NPRC”. Speculation that Prospect is propping up its largest investment (19% of its portfolio) has obviously hurt its stock. Also of note: the coverage of net investment income to common dividend does not factor the preferred dividends into the algebra. Total dividends (preferred and common) paid out in 4QFY24 annualized were $409.0 million or $0.97 per common share, versus net investment income of $1.02 a share in FY24. This is not to suggest anything untoward for management, just that coverage is much tighter upon further inspection, leaving little chance of an increase. And with the Fed Funds rate likely to be lowered at the next central bank meeting, the interest income in its SOFR-pegged floating-rate portfolio will decline, making the coverage more tenuous. Although not enormous, a 100-basis point drop in interest rates will lower net investment income by $30.3 million or ~$0.07 a share, enough to bring the coverage under 100%. The common dividend, although consistent at $0.06 per month, hasn’t changed since 2017, when it was lowered from $0.08. Factor in general queasiness regarding any commercial real estate loan portfolio and arguments as to why Prospect is trading at a 40% discount to NAV with a just under 14% yield are complete. 4QFY24 Conference Call More evidence of this somewhat confusing financial reporting occurred when the company posted 4QFY24 net investment income of $0.25 a share, which on the surface looked impressive considering the $0.18 of disbursements to common shareholders in the quarter. However, this figure did not reflect the ~$0.06 a share distributed to preferred shareholders, underscoring the prior point concerning little wriggle room regarding the dividend. The highlight of the quarter was Prospect executing an amended and extended credit facility from a syndicate of 48 banks, securing commitments totaling $2.1 billion with a 2029 maturity. On the heels of the PXG Chapter 11 filing, Prospect clarified that it has been rotating out of its second lien assets and subordinated structured notes in favor of additional first lien assets. It was also obvious that co-founder, Chairman, & CEO John Barry was at the end of his patience. He lashed out at Wells Fargo analyst Finian O’Shea in an unhinged rant after the latter posed questions that either reflected Hedgeye’s concerns or (in some instances) were a bit sophomoric for a Wall Street analyst. Balance Sheet & Analyst Commentary As stated previously, Prospect’s NAV has fallen to $8.74 a share (as of June 30, 2024), which is down from $8.99 a share on March 30, 2024, and $9.24 a share on June 30, 2023. That said, its publicly traded debt enjoys investment grade ratings from five agencies and the average cost of its total debt is 4.25%. As for its balance sheet, the company holds debt of $2.46 billion and preferred stock of $1.59 billion against cash of $85.9 million. The gaudy dividend yield of nearly 14% has already been covered. On October 7th, the Prospect Capital announced that it had increased and extended its credit facility to just north of $2 billion. February 2024 Company Presentation Part of Barry’s frustration may have to do with the fact that O’Shea, who constitutes the entirety of Street coverage, is not a big fan of Prospect, featuring an underperform rating and a price objective of $4.50. He expects the company’s net investment income to shrink to $0.61 a share in FY25, putting the dividend at risk. O’Shea’s estimate accounts for the preferred dividend, meaning an $0.11 a share shortfall in covering the current $0.06 per month common dividend. February 2024 Company Presentation Clearly unconcerned is Barry, who purchased 3.25 million shares at an average price of $5.15 per on August 30 and September 3, 2024. President Eliasek Grier also bought a total of 10,000 shares on those same dates. The CEO now owns over 69 million shares. Verdict This is not the first time Barry has made a big purchase in 2024, having acquired 803,000 shares back in May. He is signaling to the Street that he believes in his company. However, with PIKs constituting 17% of total interest income in FY24 and his stock trading at a 40% discount to NAV, shareholders want Prospect to execute a share buyback as proof that its NAV calculation is trustworthy. However, given the nature of BDCs, that request essentially constitutes a partial liquidation, meaning less management and performance fees for Prospect Capital Management, the group charged with investing the company’s assets.  An argument can be made that the Prospect Capital Corporation dividend is safe, and given the discount to NAV, the risk/reward profile is considerably skewed to the upside, making it a solid covered call candidate. However, with the lingering doubt and very little premium in the options, the recommendation is to sit this one out.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2476908160"}