Shares of Prospect Capital (NASDAQ:PSEC) were down over 5% on Monday after rumors spread concerning a potential SEC inquiry in regards to its CLO investments. This came from an article published in Asset Backed Alert which prompted Wells Fargo analyst Jonathan Bock to downgrade the stock.
According to the article, Gifford Fong, the firm the values Prospect Capital's CLO investments, allegedly "conspired with Prospect to set improper marks for its CLO investments." In addition,the article questioned if Prospect Capital had rebuffed other valuation firms in order to avoid marking down the CLO portfolio by 20% or more. Furthermore, it was suggested that Prospect Capital's auditor BDO may come under scrutiny.
How big a deal is this?
These allegations parroted by Mr. Bock against Prospect Capital and Gifford Fong are by far the most serious I have heard. While this company has always had its fair share of naysayers, an outright conspiracy to inflate the value of the CLO investments takes the cake.
Frankly, I have a hard time taking them at face value. What he is alleging simply does not make sense when you think about it. Let's assume for a moment the reason Prospect Capital is allegedly keeping the CLO portfolio inflated is to boost fees, which happens to also be one of Bock's main complaints against the stock.
If the CLO assets were inflated by 20%, the management fees would drop by ~5%, or ~$3 million per quarter. This pales in comparison to ~$52 million Prospect Capital's insiders have spent in personal purchases of the stock in Q4 2015. I doubt these insiders would spend so much money in such a short time if these sort of shenanigans were going on.
Indeed, Prospect Capital's management plus incentive fees as a percent of total investment income have held flat for 2015 at ~28%. In dollar terms, fees actually fell slightly year over year due to the smaller asset base. Due to its low share price, the company has more or less been locked out of the capital markets for several quarters.
Yes, if one were using recent information from its peers, Prospect Capital's CLO assets are likely going to be impaired in the not too distant future. Their value has been impacted due to recent interest rate volatility and increased credit risk associated with lower oil prices. Writing them down by 10-20% would not be out of the question.
Though, keep in mind that the CLO portfolio is only a small part of Prospect Capital's overall asset base. Writing down these assets to zero, which would equate to a NAV per share decline of ~$2.75, would still have this stock trading for a 25% discount at current prices. In other words, the bad news regarding CLO was already more than being priced in.
As has been the case for a long time now, the market is shooting first and asking questions later with Prospect Capital. Investors seemingly do not trust management and do not believe the NAV is real given the severe 45% discount. In my opinion, the article and Bock's note are just playing into this distrust and adds nothing new to the table.
Is the alleged SEC inquiry real or just some wild speculation? We simply do not know. What I can say is that the investment case for Prospect Capital is becoming more dubious by the day. Even if the company were to report decent numbers when it reports on Tuesday, the fear-mongering will continue to rattle retail investors out of the stock and cause sharp sell-offs like the one we saw today.
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/we are 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.