With interest rates being next to nothing at banks, investors are hurting to find safe places where they could park their cash, and still earn decent interest. One company that has attracted a lot of interest due its 10.50% dividend yield is Prospect Capital (PSEC).
Prospect Capital is a business development company that "primarily lends to and invests in middle market privately-held companies". They "invest primarily in senior and subordinated debt and equity of companies in need of capital for acquisitions, divestitures, growth, development and recapitalization". As a Registered Investment Company ("RIC"), it has to distribute 90% of their taxable income to their stock holders. It currently distributes this as a monthly dividend. Since their IPO in July 2004 at $15/share, it has paid out over $10 in dividends. So what's not to like?
Prospect is managed by Prospect Capital Management. They earn 2% of gross assets and an incentive fee based on the performance of the investment portfolio. Gross assets means their total assets. It is different from net assets which subtracts the liabilities. This incentivizes the management to:
- Increase total assets regardless of whether it is in the best interest of the share holders in order to get a higher base management fee. Assets have grown every year since inception, and so has the management fee from $1.8 million in 2005 to more than $46 million in fiscal year 2012.
- Make speculative investments in order to earn a higher incentive fee.
One way to grow the total assets and earn a higher fee is to use leverage. Prospect has been raising more and more capital by selling debt. Their debt/equity ratio has increased from 21.2% in 2008 to around 43.9%. This increases the total assets, and puts more money in management's pocket. It also creates a better return for share holders when things are going well. However, when they are not, the losses are magnified. It is the same as an individual investors buying a stock on margin. It's great when the stock goes up, but disastrous when it goes down. Prospect indicated that they will continue to increase their leverage. "We are targeting continued growth in NII per share as we utilize prudent leverage to finance our growth through new originations, given our debt to equity ratio stood at less than 44% (and less than 36% after subtraction of cash and equivalents) as of June 30, 2012″.
Since Prospect invests in middle market private companies, there is no market to sell their investments. This creates multiple problems:
- There is no way to value impairments to the portfolio and fair value is determined by the "good faith" of the board of the directors. This is a huge conflict of interest!
- If a disastrous financial event occurs, then they will not be able to sell their investments at a fair price due to their illiquidity. This disastrous event is more probable due to the fact they are levering up the company. For example, when their debt is expiring, and the company is not doing well, they will have to either sell shares or raise debt at a discount rate.
All the aforementioned risks are all good points, but the company has returned $10 in dividends since inception on an initial $15 investment. However, at the end of June 2012, the net asset value of the company stood at $10.83. So, an investor's $15 initial investment is worth $20.83 ($10 in dividend + $10.83 in n.a.v). That is an anemic return of almost 39% over 8 years. That return is definitely not worth the risk!
If investors are still not convinced and wants to invest in Prospect Capital, wait for our next article.
Read Prospect's latest 10-K here.