- The SEC issues appear resolved and the stock has shot up as a result.
- Investors are back to salivating over PSEC's roughly 13% yield.
- Investors are ignoring concentration risk; nine investments total 64% of Net Asset Value, which is very high.
Now that the SEC issues appear to be behind Prospect Capital (NASDAQ:PSEC) and the stock has shot up $0.45 as of this writing to $10.28/share, it's time to take a look at what I believe is a risk that investors who salivate over PSEC's nearly 13% dividend ignore: concentration risk.
Simply put, PSEC's portfolio carries, in my opinion, material concentration risk with nine investments (out of 138 total) comprising approximately 64% of net asset value (NAV) and 36% of total assets. The percentage of NAV is more important since any investment loss has a direct impact on NAV. One investment comprises over 12% of NAV, a $438 million investment in Progrexion Holdings. In March 2014 Moody's assigned a B3 corporate rating to this company, and a Caa2 to the 2nd lien tranche - very deep in junk territory. Moody's estimated leverage at 7x, which appears to have risen with the cash dividends that the equity sponsor has taken out of the company - at the top of the list as the worst use of borrowed money from a creditor's perspective. I know little about this private company, which seems to have grown EBITDA significantly, and it may be a great investment. However, 12% of NAV invested in any one company, no matter the merits, is too high for these types of highly leveraged, low-rated, private equity backed credits. If this investment is a total loss, the stock price of PSEC would likely drop by over $1.00/share. Yes, there would likely be some recovery of value in a hypothetical bankruptcy, but the concentration is still high.
Next down the list is the investment in First Tower Holdings, listed at $331 million in the latest 10-Q, comprising 9.3% of NAV. Again, this may be a terrific investment but the high concentration is the issue. What is also surprising is the interest income being generated by this one investment - 20% on $273 million of outstanding revolver. This means that $55 million of interest income comes from this one investment, representing about 15% of Net Investment Income (based on $364 million of NII estimated by PSEC in its latest presentation).
Next on the list are seven investments all over $150 million: Harbortouch Holdings $279 million, Instant Web $268 million, Broder Bros $259 million, APH Property Holdings $202 million, Capstone Logistics $195 million, United Sporting $160 million, and Arctic Glacier $150 million. The top nine investments total $2.28 billion out of $3.56 billion of NAV, and $6.35 billion of total assets. A total loss of any single one of these investments would lead to roughly a $0.45 to $1.00 reduction in NAV. Note that the Harbortouch, Instant Web and Broder investments were all made in Q1 2014 ($162 million in the case of Broder), so concentration has risen significantly only in this past period.
A comparison to the only BDC larger than PSEC further strengthens the high concentration risk argument. Ares Capital Corp (NASDAQ:ARCC) has a larger balance sheet at $8.2 billion in total assets. It's largest investment comprises only 5.4% if NAV, it's number two investment 3.8% of NAV, and its top nine investments only 30% of NAV - less than half the concentration of the top nine PSEC investments (not counting ARCC's investment in "Senior Secured Loan Fund LLC" which is not an investment in a single company but a senior loan funding vehicle that makes loans to many companies in a joint venture with GE Capital). I have not studied the portfolios of the many other BDCs, but no matter the comparison, investors in PSEC must be aware of the high concentration risk.
In conclusion, I am not saying that PSEC is a bad investment or that these top nine investments are at risk of loss, simply that concentration risk is high (masked by a focus on 138 portfolio companies) and must be taken into account when evaluating this stock. Most investors ignore this risk, perhaps not realizing that only nine investments comprise nearly 2/3 of NAV (and two comprises 22% of NAV) and a high proportion of NII. Note that in the last investor conference call the first question asked, by an analyst from Barclays Capital, addressed the issue of high concentration of the Progrexion Holdings investment. I hope analysts continue to probe on the quality of these large credit positions in future calls. A 13% yield carries commensurate risk - there rarely is a free lunch.
The debt securities of PSEC are rated investment grade by S&P and I believe that this rating is appropriate, even with the concentration risk. I consider a more than 50% loss in total asset value (the level at which debt securities would start to be impaired) as a highly remote possibility.
Disclosure: I personally own PSEC shares, purchased recently due to the deep discount to NAV; given the recent rise I am strongly considering a sale with possible redeployment in other BDCs. I personally hold, and hold in client accounts, the bonds of PSEC.
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