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Summary

  • Prospect continues to restructure senior debt instruments into subordinated debt and non interest-bearing equity.
  • First Tower transaction replaced a senior instrument bearing a 20% cash coupon with a lesser instrument of 10% coupon + 7% PIK.
  • Due to its size and coupon, First Tower historically provided an outsize contribution to Prospect's Interest and Other Income, generating $65mm in 2014.

Prospect Capital (NASDAQ:PSEC) continues to restructure senior debt instruments into inferior debt of reduced coupon and non-interest bearing equity.

In the most recent quarter, Prospect restructured one of its largest investments by reducing principal outstanding by accepting non-interest bearing equity, reducing periodic interest received via a lower coupon, accepting a debt instrument of lesser security, and increasing the PIK component from zero to 7%.

This investment was just two years old on the day of restructuring.

Herewith we document actions disclosed by Prospect in yesterday's lengthy SEC Form 10-K.

Moving the Goalposts, Episode IV: First Tower Holdings of Delaware [1]

First Tower Holdings of Delaware ("First Tower Delaware," or "Holdco") is the parent holding company for First Tower LLC ("Operating Subsidiary," or "Opco"), a Mississippi corporation engaged in consumer installment lending and attached credit insurance. [2]

On June 15, 2012, Prospect initiated a $288mm investment in First Tower Delaware, consisting of a $245mm senior secured revolving credit facility, and common equity of $43mm. The commitment represented 19% of Prospect's Net Assets at origination. [3]

The credit facility is described in subsequent filings as a "first lien term loan bearing interest in cash at the greater of 20% or Libor plus 18.5% and has a final maturity of June 30, 2022." [4]

During the month of December 2012, Prospect provided an additional $20mm in funding, increasing the outstanding balance of the credit facility to $265mm. [5]

On December 30, 2013, Prospect funded an additional $8.5mm of debt and $1.5mm of equity, bringing total outstanding debt and equity to $318mm. This transaction appears coincident with an $8mm fee payment from First Tower to Prospect. [6]

On June 24, 2014, Prospect provided entirely new funding of $251mm directly to First Tower LLC (the Operating Subsidiary), which it classifies as a Subordinated Term Loan, of 10% coupon plus a 7% PIK, due 2019. [7]

Operating Subsidiary then remitted this money via an intermediary to its parent, First Tower Delaware (i.e. "Holdco"), which then handed it right back to Prospect. [8]

Prospect recognized the $251mm as partial repayment of the then-$275mm outstanding on the senior secured credit facility.

The remaining $24mm of outstanding senior debt ($275mm less $251mm repaid) was restructured into additional non-interest bearing equity of First Tower Delaware.

Note that Prospect already owned 100% of the equity of First Tower Delaware prior to the additional equity issuance. [9]

Restructuring or Impairment?

The June 24th transaction has four material features

  • New loan of lower principal than the loan it replaced
  • New loan of lesser seniority than the loan it replaced
  • New loan of materially higher PIK component than the loan it replaced
  • Prospect owns more non-interest bearing equity in Holdco as a percent of total investment.

A review emphasizing substance rather than form would conclude the transaction represented an economic impairment of one of Prospect's largest and most significant loans.

Conclusions

The 10-K is almost 400 pages long and discloses several additional transactions with holding companies. [10]

While analysts may superficially focus on Prospect's inadequate dividend coverage and rapid declines in NAV, significant additional due diligence is necessary to characterize changes in both credit quality of the loan book and implications on forward investment yield.

COMPANIES MENTIONED

Prospect Capital Corporation

ENDNOTES

[1] For additional Prospect debt restructurings, see Moving the Goalposts I and II, in "Prospect's Growth Hides Bad Underwriting" and Moving the Goalposts, Episode III in "Meet NMMB Holdings."

[2] The corporate structure is described more fully as follows. Prospect owns 100% of First Tower Holdings of Delaware ("First Tower Delaware"). First Tower Delaware owns 80% of First Tower Holdings LLC, which in turn owns 100% of First Tower LLC ("First Tower"), which is the operating company. c.f. Prospect Capital SEC Form 10-K, 2012, p. 62.

[3] For initiation of investment, see Form 10-K, 2012, p. 146. For itemized securities, see Consolidated Schedule of Investments, p. 105.

[4] Prospect Capital SEC Form 10-K, 2014, p. 66. I initially thought the "first lien" description might only apply to the additional debt funded in Dec 2013, but a separate class of debt is not enumerated in the consolidated schedule of investments for either Dec 2013 or Mar 2014. See Form 10-Q, March 2014, p. 8. Based on this analysis, I conclude the descriptions are co-referent.

[5] Prospect Capital SEC Form 10-K, 2013, p. 96.

[6] See both Footnote (40) to Consolidated Schedule of Investments, SEC Form 10-Q (Sep. 2013), p. 40 and Footnote (42) to Consolidated Schedule of Investments, SEC Form 10-Q (Dec. 2013), p. 39.

Also, see "Intra-quarter conversions from Capital Account to Income Through Wholly-Owned Holding Companies."

[7] Consolidated Schedules of Investment, Prospect Capital SEC Form 10-K, 2014, p. 104.

[8] Note (29) to Consolidated Schedules of Investment Form Prospect Capital SEC Form 10-K, 2014, p. 131.

[9] Prospect Capital SEC Form 10-K, 2012, p. 62.

[10] Note (46) to Consolidated Schedules of Investments, Prospect Capital SEC Form 10-K, 2014, p. 134. Also see additional disclosure on p. 71.

Source: Prospect Capital: More Restructuring Of Senior Portfolio Debt - Meet First Tower