Why I Sold Prospect Capital

Jun.19.14 | About: Prospect Capital (PSEC)


With shares rallying back towards book value, I decided to sell my PSEC holding.

Low rates forces PSEC to make riskier loans, which is a dangerous strategy as shown by the recent bankruptcy of New Century.

Its management structure also incentivizes risk taking, which could cause problems in the future.

With a chance for further book value declines, PSEC is risky even if its dividend is nice.

Over the past few weeks, Prospect Capital (NASDAQ:PSEC) has been an embattled company, having reported a mediocre quarter and faced off the SEC on an accounting issue. These problems sent shares lower, piercing the $10 level. At this point, I recommended you purchase shares of PSEC as shares were trading at an over 7% discount to book value and the SEC dispute was not going to impact PSEC's dividend policy. With shares having rallied somewhat and other issues arising, I decided to sell my holding this week. I would suggest other investors consider trimming their holdings as well even though the dividend can be hard to resist.

With a business development company ("BDC") like Prospect, investors are really buying the balance sheet, which is mainly debt investments in small companies funded with debt and equity. As a consequence, BDCs often trade near book value. At the end of last quarter, book value stood at $10.68, which is about 3% higher than shares (all financial and operating data available here). On this basis, Prospect seems reasonably valued. However, a decline in book value could result in a corresponding decline in shares. If the portfolio companies are unhealthy and default, PSEC shareholders will obviously have a tough time. I am increasingly concerned about this.

Last week, one of Prospect's companies, New Century Transportation, filed for Chapter 7 bankruptcy (more details can be found here). This loan of $44 million was originated in August 2012 and was held at par value until March when it was impaired down to $36 million. Depending on this proceeding, Prospect could be left with pennies on the dollar. The hit to book value from this bankruptcy alone could be $0.10. Losses like this can add up and quickly erode the value of the stock. Maintaining strong underwriting standards is critical, and this bankruptcy coupled with several other soured investments suggests that underwriting standards may not be at a level I am comfortable.

A reason for this is the low interest rate environment. Cutting a dividend is a certain way to kill a stock price, and BDCs are mainly owned for their income. As a consequence, PSEC works very hard to maintain its $0.11 monthly payout. With a yield of over 12%, PSEC has a relatively high cost of capital, and it can be difficult to find investments that generate sufficient return. With corporate bond spreads at or near all-time lows, BDCs like Prospect have to move into riskier credits to get a sufficient yield. However, this raises the potential for bankruptcies and impairments. Should the economy enter a recession in the next 24-36 months, other risky investments could follow New Century's lead. In a sense, PSEC's high dividend policy necessitates a riskier portfolio, which increases the probability of a decline in book value. While its portfolio of floating rate debt could do well if rates ever do rise, this prolonged period of low rates is forcing more risk into the balance sheet.

Adding to this, Prospect Capital is managed by Prospect Capital Management, which has a pay structure similar to the General Partner of a Hedge Fund. In calendar 2014, management fees could be roughly $100 million or nearly $0.30 per share. According to its prospectus, management is paid 2% of net assets and receives a portion of interest income above 7%. In other words, management gets paid to make higher interest loans, which does generally make sense. However in this low rate world, it could lead to an erosion in underwriting standards to maximize current management fees. Between the dividend and management structure, underwriting problems could continue in coming quarters, leading to a further decline in book value beyond the $0.10 from New Century.

At an only 3% discount to book value, I believe this risks are not being fully accounted for and could threaten the dividend in future years. With shares having recovered most of the SEC-related issues, I think now is a good time to take money off the table as fundamental issues are starting to pile up. If shares start trading 7-10% below book value again, I would consider buying back in as more of the risk if priced in. But for now, I am comfortable having sold PSEC.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.