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Summary

  • Prospect Capital is down in recent weeks due to concerns regarding BDC listings in the S&P and Russell indexes.
  • SEC rules require index linked ETFs to add the cost structure of BDCs to their own cost structure, slightly inflating reported expense ratios.
  • ETFs have successfully lobbied to have the BDCs removed from the exchanges.
  • As much as 8% of BDC stock owned by the ETFs may be sold over the next few weeks.

Prospect Capital (NASDAQ:PSEC) sure has had a rough few weeks, with the company declining nearly 5%, an unusually large move for the stock. However, this decline seems to be an overreaction. Prospect Capital is a business development company, or BDC, which typically invests in private company debt, equity and other high return investments. The stock is well known among income investors for its outsized 12.20% yield, paid monthly.

Why has Prospect Capital declined?

As noted above in the summary, BDCs are likely being removed from the Russell index. Russell mentioned this in a note to its clients stating that unless the SEC changes the fee-reporting standards of BDCs, it will remove BDCs from its indexes during its June reconstitution. This follows a similar move from the S&P Dow Jones.

It is very likely that in the coming weeks ETFs that are linked to these indexes will become sellers of stock in BDCs such as Prospect Capital. With an estimated 8% of all BDC shares held by ETFs linked to the Russell alone, this is no small matter.

In addition, it will take time to unload these shares. According to several reports, ETFs own several weeks' worth of average daily trading volume for some of the smaller BDCs. ETFs were also a major buyer of shares in BDCs. With their volumes removed, some BDCs may become more volatile due to increased illiquidity.

Why are the indices kicking out the BDCs?

There is a very simple reason as to why the ETFs are asking to remove BDCs from the indexes, namely expense ratios. With the increased popularity of low cost ETFs, oftentimes the only distinguishing factors between different competing products are their expense ratios. The lower this ratio, the higher the AUM often became.

However, ETFs fall victim to an antiquated 1940s SEC rule "Acquired fund fees and expenses" ("AFFE") requiring them to add the cost structure of the BDCs to their own costs.

Vanguard explains this rule as follows:

"Acquired Fund Fees and Expenses" are expenses incurred indirectly by the Fund through its ownership of shares in other investment companies, such as business development companies. These expenses are similar to the expenses paid by any operating company held by the Fund. They are not direct costs paid by Fund shareholders and are not used to calculate the Fund's net asset value. They have no impact on the costs associated with fund operations. Acquired Fund Fees and Expenses are not included in the Fund's financial statements, which provide a clearer picture of a fund's actual operating costs."

The net effect of having BDCs in ETFs is the increasing of the reported expense ratio by a few basis points. While this doesn't seem like much, in the eyes of the large ETF providers, this was more than enough reason to call for their removal from the indexes.

Recent turmoil is a buying opportunity

With Prospect Capital, much of the fear seems to be way overblown. The stock may come under very short-term pressure due to ETFs selling out their holdings. However, Prospect Capital has much stronger liquidity and trading than the average BDC. Indeed, holdings via the Russell linked ETFs account for less than 10 days' average trading volume. Therefore it seems unlikely this selling will have much of an impact.

Indeed, this selling is merely due to an SEC rule technicality and subsequent ETF pressure. There is a very slim outside chance that the SEC does act to amend its rules regarding BDCs, however, this seems unlikely.

Furthermore, this selling has nothing to do with Prospect Capital's long-term potential or fundamentals.

The stock is now trading very near its Q4 2013 NAV of around $10.73 per share. In addition, Prospect Capital has already announced monthly dividends through September 2014, essentially locking in strong monthly income medium-term.

While NII has come down in recent quarters, it still mostly covers the current dividend, especially when factoring in the large gains from equity holdings. In addition, Prospect Capital still is relatively underleveraged compared to other BDCs, with a debt to equity ratio at about 48.0%.

Conclusion

In my opinion, the recent decline in Prospect Capital's share price is a clear buying opportunity. Yes, the ETFs will likely start selling their stock in anticipation of the Russell index changes. However, given Prospect Capital's size and high liquidity, the impact may be minimal.

You'll find few 12% yielders trading right around NAV. I expect the stock to slowly recover and once again trade above $11.00 per share fairly soon.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: I am long PSEC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.