Prospect's Growth Hides Bad Underwriting

Mar. 3.14 | About: Prospect Capital (PSEC)

36% Of End-Of-FY09's Loan Pool Terminated In Write-Off, Non-Accrual, Or Restructuring As Marked-Down Junior Equity.

In response to sharp criticism of my brief sketch of Prospect Capital Corporation (NASDAQ:PSEC), I elected to do a comprehensive review of its published financials and share the results. [1]

My earlier discomfort with Prospect's exhibit now grows acute. Prospect proposes to acquire Nicholas Financial (NASDAQ:NICK) in a stock-for-stock transaction. Shareholders of Nicholas should not accept such shares as merger consideration.

Herewith my analysis of Prospect, informed by the leading question:

What is The Intrinsic Risk of Borrower Default in PSEC's Exponentially Growing Loan Pool?

Rapid growth in a loan portfolio masks actual underwriting results. If the book has grown by a factor of, say, ten, over the maturity of a loan, even commercially disastrous results in the initial, aged cohort will be but a rounding error when compared to the present younger-and-larger pool.

Prospect ("PSEC" or "Company") has experienced such growth: Investments have risen fifty-fold from $94mm at the close of Fiscal Year 2005 (June) to $4.9b today. Net Assets traced a similar climb from $103mm to $3.2b. [2]

Chart 1: Exponential Expansion of Prospect's Balance Sheet (2005-Present)

Source: Company Filings

Thus, the only reliable method for computing the intrinsic risk of credit-default in the borrower-population is to track the results experienced by a specific group of loans over a defined period of time. [3]

The Class of 2009: We Compare a Static Group of Loans to Itself, Not Subsequent Lending.

I selected the group of loans on the book at fiscal-year-end 2009, and, using subsequent SEC filings, documented their development over the next 4.5 years. 2009 represented the median year of published data (2005-2013), indeed of the Company itself, and post-dated the credit events of mid-2008 through early 2009. [4]

I found debt-instruments comprising 36.1% of End-of-FY09 Loans and 29.3% of Net Assets (such ratios computed using Disclosed Fair Value), were in non-accrual, had been written off, or were restructured into impaired junior equity by calendar-year-end 2013, the last date for which I had filings. [5]

In Table 1, please find the evidence and relevant citations. The %NA ratio represents the security's Fair Value expressed as a % of Net Assets (with both numerator and denominator at Company's marks) and is taken directly from the Company's Form 10-K, 2009 without alteration or amendment. [6] The Refs: line denotes source material for the disposition of the instrument.

In balance, I note that eight of the sixteen line items, comprising 7.4% of Net Assets were already in non-accrual as of the balance sheet date, but terminated as write-offs in a subsequent period. The remaining eight items, comprising 21.9% of Net Assets were, at least initially, performing. See row marked Security: for identification of non-accrual loans at balance sheet date.

A comparison of initially performing loans alone (removing the initial 7.4% non-accruals from both numerator and denominator) would reduce the problem-group to 30% of total loans, vs. 36% in the broader analysis.

In size-rank, descending order, grouped by issuer, the 16 problem securities are:

Table 1: Prospect's Loan Class of 2009

Details of Debt Instrument




H&M Oil and Gas


Senior Secured 13%, 2013

Non-accrual, 6/30/2011



Form 10-K, 2011, p. 79


Stryker Energy


Sub. Secured Rvlvr, 12%, 2011

Non-accrual, 12/1/2011



Form 10-K, 2012 p 113


Yatesville Coal Holdings


Junior Secured Note, 15.72% 2010 *

Impaired Dec 31, 2009


Senior Secured Note 15.72% 2010 *

Impaired Dec 31, 2009



Form 10-K, 2011 p. 79


Wind River Resources


Senior Secured 13%*

Written down in 2013



Form 10-K, 2013 p. 140


Iron Horse Coiled Tubing


Senior Secured 15% + 3% PIK, 2009

Both: in Non-accrual (2010).


Bridge Loan 15% + 3% PIK, 2009

Both: restructured 1/1/10 w/ no-interest



for non-accrual: 10-K, 2010, p 108

Both: 6/11-6/12 principal repaid w/o interest

for restructuring: 10-K, 2010, p.70

in consideration for Prospect-held shares

for principal repayment in exch. for shs:

representing 52.8% of Iron Horse common

10-K, 2013 p 155


Ajax Rolled Ring


Sub. Secured 11.5% + 6% PIK, 2013

Serially restructured to jun. equity.



see "Moving The Goalposts I: Ajax…,"

Equity written down 12/31/13



Freedom Marine


Sub. Secured Note, 12%+4% PIK, 2011

Non accrual 10/1/2010



Form 10-K, 2011, p. 102


Conquest Cherokee


Sen. Secured Note, 13%*

Foreclosed and consolidated



Form 10-K, 2010, p.96

with Coalbed LLC 12/09


Deb Shops


Second Lien Debt, 8.67%, 2014

Written off 9/30/2011



Form 10-K, 2013, p. 109


Integrated Contract Services


Junior Secured 7% + 7% PIK *

Written off, 12/31/12


Senior Secured 7% + 7% PIK *

Written off, 12/31/12


Senior demand note, 15% 6/30/09

Written off, 12/31/12



Form 10-Q, Q2 2014 [Dec 2013], p. 29


Appalachian Energy Holdings


Sen. Secured Tr-B 14% + 3% PIK *

Both: Rolled into Manx. 1/19/10


Sen. Secured Tr-A 14%+3% PIK *

Both: Written-off 6/30/11



Manx, write down: 10-K, 2011, p. 78

Fair value: see p. 103

Problem Loans to Net Assets


Total Loans to Net Assets (calculated directly, but see also: 10-K, 2009, p.60)


Problem Loans to Total Loans


Click to enlarge

Source: Consolidated Schedules of Investments, Form 10-K, 2009, pp. 79-92, additional documentation per security & issuer as identified intra-table by 'Refs:'

Note (*): In non-accrual at Fiscal Year End-2009.

Restructure Debt into Equity, Then Write-down.

It is oft repeated by Prospect management that no new investments since 2008 have experienced a default or non-accrual. That may be technically true yet of little significance. Goalposts may be moving vs. footballs flying straight and true. [7]

Moving the Goalposts I: Ajax Rolled Ring Subordinated Secured 2013s.

Ajax Rolled Ring ("Ajax") is a South Carolina forger of steel rings. [8]

Over five years, Prospect refinanced Ajax's original Subordinated Notes into a Term Loan, then into Preferred Shares, which were almost immediately written down to pennies on the dollar. I characterize this sequence of re-financings and mark-downs as a constructive write-off of the initial Subordinated Debt Commitment to in substance, if not form.

Details are provided for the interested reader.

On April 1, 2008, Ajax issued (to Prospect) a Subordinated Secured Note, 11.5% coupon + 6% PIK, due 4/1/2013 of face value $11.5mm in consideration for cash received. At the time, the commitment represented 2.6% of Prospect's Net Assets. [9]

Through the interval ending in December 2012, amounts outstanding increased to $15mm. [10]

Prospect disclosed difficulties with Ajax's underlying business. The security experienced fluctuations in value, and was marked down to 60% of par at end fiscal 2010, though marked back up over the successive two years. [11]

On December 28, 2012, Ajax issued another Subordinated Unsecured Note, par value $3.6mm, in consideration for new cash from Prospect. [12]

The total outstanding under the two Subordinated securities (Secured and Unsecured) now stood at $18.635mm ($15.035 + $3.6).

On April 1, 2013, Prospect provided Ajax with an additional $19.7mm in funding. In return, Ajax repaid both Subordinated notes, and issued a new $19.7mm Subordinated Unsecured Term Loan, ("Term Loan") due 2018 bearing an 11.5% coupon + 6% PIK.

Thus, Prospect accepted a larger instrument, of similar coupon, but inferior in the capital structure. [13]

Events progressed rapidly over the next 8 months.

On October 11, 2013 Prospect provided Ajax with $25mm in funding. [14] In return, Ajax repaid the entire Term Loan (which had grown to $20mm) and issued $25mm in Series B Convertible Preferred Shares ("Ajax Preferreds").

Yet again, Prospect accepted a larger instrument, inferior in the capital structure.

Just six weeks later, on December 31, 2013, (i.e. intra-quarter) Prospect marked the Fair Value of the Ajax Preferreds down to $0.20 on the dollar, a $20mm mark-down. [15]

Moving the Goalposts II: Gulf Coast Machine Senior 2017s.

Ajax involved Subordinated Debt. Here's an example of the same pattern with recently issued Senior Debt.

On October 12, 2012, Prospect invested $42mm with Gulf Coast Machine and Supply Company ("Gulf Coast"), receiving a Senior first lien Note, 10.5% coupon due 2017. At the time, the commitment represented 1.8% of Prospect's Net Assets. [16]

By September 30, 2013, the investment was in trouble. Citing "deterioration of operating results" Prospect reduced Fair Value to $13mm, a 70% decrease. [17]

On November 8, 2013, Prospect provided an additional $26mm of funding to Gulf Coast, receiving partial repayment of the Senior Notes [leaving a $15mm balance outstanding ($41.2mm-$26mm = $15mm)] in exchange for $26mm of Convertible Preferred ("Gulf Preferreds").

Prospect immediately (again, intra-quarter) marked the Gulf Preferreds down to zero. [18]

Underwriting Disaster or Rounding Error?

We presented some unfortunate outcomes within the Class of 2009. The bad results comprise a hefty share of their own cohort, yet shrink to a mere 4% and 3% when compared to today's much larger Net Assets and Investments. [19]

Such is the basic math of six- and nine-fold growth.

Will the company grow to $45b of Investments in the next 4.5 years, so that today's problem children again become tomorrow's rounding errors?

If not, outcomes in line with the Class of 2009 will have material negative effects across all of Prospect's capital structure.

Prospect's Interest Rates Too Low to Compensate for Experienced Rates of Credit Default and Cumulative Realized Losses.

If a third of loans are not coming back, interest rates in the teens seem insufficient to make up for capital loss, absent large realized gains on the sales of portfolio companies where debt has been restructured into an equity instrument.

Yet to date, filings show cumulative net realized losses of $64mm over the last five years and lifetime net realized losses of $78mm. [20], [21]

In any event, restructurings of debt into equity, such as the two examples above, should reduce overall yield as portfolio duration increases, and may force Prospect to adopt an increasingly leveraged capital structure to maintain its ROE (and its high dividend yield to shareholders). Prospect's net Investment yield (Net Investment Income/Investments) has already sunk below its current dividend yield of 11.9% by almost 450 basis points. [22]

Thus, I believe interest rates need to be significantly higher in light of both the experienced and foreseeable risks to the portfolio.

Prospect is Giving away Dollar Bills for Fifty Cents.

In that light, the exponential loan growth makes more sense. Prospect is giving away dollar bills for $0.50. No wonder demand is robust.

Prospect is charging its borrowers too little to compensate for the intrinsic risk of capital loss. This makes borrowers happy. The work done by Prospect's economic engine is a net transfer of money from equity investors to borrowers via mispriced credit risk. [23]

Prospect Capital is Only Dancing Until the Music Stops.

As a stock, Prospect will work as long as the defaults, which take time to emerge, are compared to the so-much larger pool of today's loan assets, and not against the much smaller loan pool in place when the original commitments were made.

But when growth stops, the bad outcomes as a percentage of loan assets will begin their inexorable rise, and shareholders will be left with:

  • A badly underwritten book of illiquid loans and junior equity with no public market or marks.
  • Duration mismatch between Debt and Assets.
  • Reduced access to funding markets.
  • Capital destruction. [24], [25]

What To Do?

No one will want to be a Prospect shareholder when that day arrives, and I hope current Nicholas shareholders, as potential Prospect Capital owners, carefully review my analysis and vote accordingly.

I express no opinion on what current Prospect shareholders should do with their shares.


Prospect Capital Corporation

Nicholas Financial, Inc.


[1] "Nicholas Financial: A Bad Deal - Vote It Down." Galler, L.Z., Seeking Alpha, Feb 21, 2014.

[2] The expanding difference between the two time-series reflects Prospect's increasing use of gearing. Debt of just $100mm in 2010 has grown eighteen-fold to $1.8b (Form 10-Q, Q2 2014 [Dec-2013], p. 3).

[3] For emphasis: you can easily calculate a non-useful measure of the intrinsic risk of credit default in the borrower population by dividing the much smaller dollar amount of older, defaulted loans by the greater denominator of today's total outstanding loans. In contrast, our methodology compares a static group of loans to itself (i.e. static in composition), and does not attempt to make a comparison within a dynamic, ever-growing, portfolio (i.e. non-static in composition). Note, importantly, that a growing pool becomes in duration, younger, while one in contraction becomes older.

[4] Conveniently, 2009 Net Assets of $533mm are within 3% of Total Investments of $547mm (Form 10-K, 2009, p. 75). Readers who prefer to consider default ratios denominated by Total Investments rather than Net Assets can safely do so. In the 2009 static pool analysis they are substantively interchangeable, though this is not true for later periods.

[5] At 2009 year end, Loans represented 81% of Net Assets (Form 10-K, 2009, p. 75). Ratios calculated against the denominator of Loans will thus be 23% higher (the reciprocal of 0.81) that those computed against Net Assets.

[6] See: Consolidated Schedules of Investments. Form 10-K, 2009 pp. 79-92.

[7] See for example: Prospect Press Release, Prospect Capital Announces 83.6% Increase in Net Income for Second Fiscal Quarter Over Prior Year, dated Feb 3, 2014, Portfolio and Investment Activity, paragraph 9. "None of the loans in our portfolio originated in over six years has gone on non-accrual status."

For amplification, see Prospect Capital Corporation President M. Grier Eliasek Talks 12% Yields, without credited authorship, dated Feb 14, 2014. "`We have not originated a new investment in over six years that has experienced a payment default or non-accrual,' said Eliasek." [Emphasis added]

Ajax-related Footnotes

[8] Form 10-K, 2008, p. 48.

[9] Form 10-K, 2008, p. 62.

[10] Form 10-K, 2012, p. 104.

[11] For writedown, Form 10-K, 2010, p. 84. For markups, Forms 10-K, 2011, p. 102 and 2012, p. 104.

[12] Form 10-Q, Q2 2013 [Dec-2012], p. 7.

[13] Form 10-K, 2013, p. 94.

[14] Form 10-Q, Q2 2014 [Dec-2013], p. 85

[15] Form 10-Q, Q2 2014 [Dec 2013], p. 85.

Gulf Coast-related Footnotes

[16] For transaction description, see Form 10-K, 2013, p 83. For initial Fair Value mark, see Consolidated Schedule of Investments, Form 10-Q, Q2 2013 [Dec-2013], p. 12.

[17] For "significant decreases," see Form 10-Q, Q1 2014 [Sep-2013], p 51. For Fair Value mark, see Consolidated Schedule of Investments on p. 14.

[18] For the refinancing see Form 10-Q, Q1 2014 [Sep-2013], p 79. For Fair Value marks see Consolidated Schedule of Investments on p. 8. For what disclosure exists on the zero-Fair Value markdown of the Preferreds, see p. 52.

Return-of-Capital vs. Return-on-Capital related Footnotes

[19] Form 10-Q, Q2 2014 [Dec-2013], p. 3.

[20] For emphasis: There are cumulative net realized losses, not gains, over the review period. Indeed, Prospect has produced an even greater lifetime net realized loss of $78mm (see Forms 10-K, 2013, p.109 for period 2011-2013, 10-K, 2011 p. 109 for period 2009-2011, and both 10-K 2009, p. 70, and 10-K 2007, p. 44 for all earlier periods). In fairness, we did find some successful sales, including NRG Manufacturing in 2012.

[21] With reference to Gas Solutions Holdings, a successful 2013 exit: Prospect has always held a 100% equity interest therein, the sole controlled-investment in its earliest 10-K (Form 10-K, 2005, p. F-3, esp. p. F-5 note 4). Such equity was not obtained through a restructuring of a problem loan.

[22] Net Investment Income (NII) divided by end-of-period Investments stood at 7.8% at end of FY2013 and shows a declining time series (see Item 6. Selected Financial Data Form 10-K, 2013, p. 69).

In fairness, rapid growth in the denominator almost surely distorts the metric, but computing a run rate based upon just the most recent quarter indicates an even skinnier Investment yield of 7.5%. (Form 10-Q, Q2 2014 [Dec-2013], pp. 3-4)

[23] Management also transfers quite a bit to themselves, at 2% of gross assets per annum (see Note 12: Related Party Agreements, Form 10-K, 2013, pp. 190-191).

[24] As with most historical investment structures of PSEC's canonical class, the timing of the decline is the dependent variable, and Asset Growth the independent.

[25] For those readers fond of magic and understandably less fond of finance, I break Prospect's trick down into familiar terms.

  • The Pledge: No Default or Non-Accruals on Investments.
  • The Turn: Transmute 'base and ordinary' shareholder capital to portfolio-company debt, then debt to equity. Quickly, write down the equity in an intra-quarter puff of white smoke.
  • The Prestige: With cumulative net realized losses, the audience is still waiting on the final third of the trick.

Sadly, our ordinary object, handed so eagerly to the man upon stage, may never return.

Disclosure: I am long NICK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.