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Prospect Capital Monitor is a resource independent of the Company for breaking news and financial analysis about Prospect Capital Corporation (NASDAQ: PSEC) a publicly-traded business development company (BDC). Prospect Capital Monitor aims to provide honest analysis of Prospect Capital and the... More
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  • Prospect Capital An Outlier In Share Issuance: Issuance Hasn't Translated Into Significant Gains For Shareholders 0 comments
    Feb 17, 2014 5:49 PM | about stocks: PSEC, FSC, MAIN, ARCC, AINV, ACAS

    Prospect Capital Corp. (NASDAQ: PSEC), is a business development company (NYSE:BDC) that lends money to and exercises equity participation in small and mid-sized companies. As a BDC, Prospect is required to pay out at least 90% of its net investment income in dividends and its debt/equity ratio is limited to no more than 1:1. Because of this debt/equity limit, Prospect and other publicly-traded BDCs often issue equity to raise capital. Equity issuance exerts a downward pressure on a company's share price and earnings per share by increasing the supply of outstanding shares. This report finds that:

    • Prospect has increased its number of shares outstanding by 246% in the past three years ending September 30, 2013, three times more than the average of the ten largest BDCs.
    • In the same three-year period, Prospect's rapid equity issuance did not significantly increase net asset value per share, which grew 4.7% compared to the 20.3% average NAV growth of the ten largest BDCs. In the year ending in 9/30/13, Prospect issued 98 million new shares, increasing its shares outstanding by 57% while its NAV per share decreased by 1.5%.
    • Prospect's fees and expenses relative to investment yield spiked during 2012, cutting into profitability.
    • Prospect's most recent and largest secondary offering of 35 million shares on November 1, 2012, resulted in an 8.9% share price drop.
    • Since its November 1, 2012 secondary offering, Prospect has issued an additional 75 million shares through its ATM program and through portfolio investments. Prospect has scheduled the additional future issuance of the equivalent of 70 million shares at the latest conversion rate through convertible bonds.

    The first report in this series found Prospect to have performed worse than all but one of the fifteen largest BDCs in a recent one year period in terms of total shareholder return (TSR). This report investigates Prospect's recent profitability in the context of its equity issuances, and asserts that Prospect's rapid share issuance has contributed to its poor TSR.

    Comparing Equity Issuance of Large Business Development Companies

    Of the ten largest BDCs, Prospect has grown its number of shares outstanding at the greatest rate in the last three years.

    (click to enlarge)

    Ten largest BDCs by Market Capitalization.1 Shares outstanding from SEC quarterly reports on quarter ending 9/30/10 -quarter ending 9/30/13.

    In the short term, rapid equity issuance depresses share price and earnings per share through over-supply of shares. The longer term effects of rapid share issuance depend on Prospect's ability to deploy its equity capital profitably. Prospect must increase net investment income and net asset value at pace with the increase in its supply of shares in order to maintain its net investment income and net asset value per share.

    Prospect's equity issuance is triple the average of the ten largest BDCs during the three year period ending September 30, 2013, yet Grier Eliesek, President and COO of Prospect Capital Corp. asserts that Prospect has been growing "at a solid and prudent pace".2 According a recent report on middle market lending released following the fiscal quarter ending June 30, 2013, "lenders continue to 'chase' risk in response to dearth of quality opportunities".3 Prospect Capital Corp. raised significantly more equity capital which chased profitable investments during the past three years than its peers.

    Because BDCs commonly invest in companies which are highly-leveraged, rated below investment grade, or are unrated, BDCs can experience realized and unrealized losses on their investments. During its 2013 fiscal year, Prospect reported $104 million in investment losses and unrealized depreciation, which diminished PSEC's net investment income (NYSEMKT:NII) by 32%. NII with realized losses and unrealized depreciation factored in was $51 million less than dividends paid in the fiscal year, or $1.07 per share (25 cents below their 6/26/13 annualized dividend of $1.32 per share). If this level of realized losses persists with the many investments Prospect is currently making, it will have to cut its dividend. During the same period, Prospect earned $1.2 billion from selling new equity. Prospect's equity issuance has put significant pressure on the company to find profitable investments with minimal long-term losses and depreciation.

    Ten Largest BDCs, ranked by 3-year increases in outstanding shares (9/30/10 - 9/30/13):

    Ten Largest BDCs by Market Capitalization1

    # of shares outstanding on 9/30/10 (in millions)

    # of shares issued

    (in millions)

    % change in shares outstanding

    Average % per-year increase in shares outstanding

    % change in NAV per share

    Prospect Capital Corp. (NASDAQ, PSEC)

    78

    +193

    246%

    82%

    4.7%

    Main Street Capital Corp. (NYSE, MAIN)

    19

    +21

    113%

    38%

    57.2%

    Triangle Capital Corp. (NASDAQ, TCAP)

    15

    +13

    86%

    29%

    32.9%

    Fifth Street Finance Corp. (NASDAQ, FSC)

    55

    +84

    155%

    52%

    -5.6%

    PennantPark Investment Corp. (NASDAQ, PNNT)

    36

    +30

    84%

    28%

    -1.9%

    Hercules Technology Growth Capital (NYSE, HTGC)

    36

    +26

    71%

    24%

    11.3%

    Ares Capital Corp. (NASDAQ, ARCC)

    193

    +76

    39%

    13%

    13.3%

    Solar Capital Ltd. (NASDAQ, SLRC)

    33

    +11

    34%

    11%

    0.7%

    Apollo Investment Corp. (NASDAQ, AINV)

    194

    +30

    16%

    5%

    -13.4%

    American Capital Ltd. (NASDAQ, ACAS)

    341

    -64

    -19%

    -6%

    103.8%

     

    Average:

    +42

    82%

    27%

    20.3%

    Investors should be aware that among the ten largest BDCs, the average increase in shares outstanding over this recent three year period was 82%, indicating that many BDCs utilize dilutive equity issuance to raise capital and to keep down their D/E ratio. Prospect however utilizes dilutive equity issuance to a much greater extent. Like Prospect Capital Corp., many of the ten largest BDCs had difficulty raising their net asset values per share in this same period. However, some large BDCs such as MAIN, TCAP, HTGC, ACAS and ARCC, did increase their NAV per share significantly during the period since the financial crisis, while engaging in varying but smaller amounts of equity issuance than Prospect. Prospect's NAV per share remains 25-29% below its pre-crisis level.

    (click to enlarge)

    Comparing Prospect's Equity Capital Raised with its Returns to Shareholders

    Prospect Capital Corp.'s rapid share issuance has so far not significantly benefited shareholders in terms of NAV per share. While Prospect increased its outstanding shares by 246%, its NAV per share treaded water, increasing by 4.7%, compared to its peer average of 20.3% NAV growth. In the year ending in 9/30/13, Prospect issued 98 million new shares, increasing its shares outstanding by 57% while its NAV per share decreased by 1.5%.

    While Prospect's strategy has not rewarded shareholders with significant NAV per share growth, it has rewarded Prospect Capital Management, PSEC's external manager. Prospect Capital Management's base management fee has increased 439% and roughly doubled per employee during the same three-year period in part because of Prospect's rapid equity issuance. Prospect Capital Management's base fee is calculated as 2% of gross assets and increases with every origination, regardless of the quality of the investment or its effect on NAV per share or share price.4 Although this pay structure is common to BDCs, Prospect Capital Management has benefited from it more than its peers by pursuing more rapid equity fund-raising. Relying heavily on equity issuance to raise capital represents a potential misalignment of interests between management and shareholders. For shareholders, the quality of Prospect's investments matters more than quantity.

    (click to enlarge)

    Prospect's Fees and Expenses:

    Another measure of the success of Prospect's equity issuance can be found by comparing Prospect's annualized fees and expenses associated with its equity issuance with its current annualized yield of interest bearing investments. The difference or spread between these two figures approximates Prospect's profit margin from interest bearing investments.

    (click to enlarge)

    *Annualized current yield of all interest bearing investments. **Weighted as a percentage of interest bearing investments so that fees and expenses can be directly compared to annualized yield. Includes management and advisory fees, total interest expense, acquired fund fees and expenses, and other expenses. Represents costs and expenses that an investor in the equity offering will bear directly or indirectly.5

    Prospect's fees and expenses spiked during 2012 to a peak of 13.97% of interest bearing investments, exceeding yield during September 2012.The trend lines above suggest a tightening of Prospect's spread between yield and fees and expenses over the long term. This tightening fits the context of the increasingly competitive middle market in which Prospect has needed to deploy large amounts of capital raised through its rapid equity issuance. It is worth noting that Prospect's spread tightening has coincided with its most rapid period of equity issuance. Wells Fargo Equity Research analysts noted of Prospect following Q1 2014, "We believe investors will likely question the heavy equity issuance should weighted average yield continue to decline."6

    A Closer Look at Prospect's Recent Equity Issuance History

    Prospect's Most Recent Secondary Offering:

    (click to enlarge)

    PSEC shares have yet to recover to their November 1, 2012 pre-secondary closing price, its largest secondary which increased its number of shares outstanding immediately by 20.1%.7 Periodically since November 1, 2012, Prospect has issued 75 million total additional shares through its ATM program and through portfolio investments. Similarly sharp share price depreciation occurred after most of Prospect's five secondary offerings in the last three years.

    Three years of large secondaries:

    Date

    Number of Shares Issued

    % Increase in Shares Outstanding

    Closing Price, Day of Secondary8

    Next Day Closing Price

    Share Price Decrease

    Total Annual Fees and Expenses Associated with the Offering, or Equity Cost of Capital*

    11/1/2012

    35,000,000

    20.1%

    $11.92

    $10.86

    -8.9%

    12.46%9

    7/10/2012

    21,000,000

    14.8%

    $11.90

    $10.94

    -8.1%

    12.35%10

    2/22/2012

    12,000,000

    10.9%

    $11.26

    $11.06

    -1.8%

    10.99%11

    6/20/2011

    10,000,000

    10.3%

    $10.64

    $10.17

    -4.4%

    11.11%12

    4/4/2011

    9,000,000

    10.2%

    $12.20

    $11.61

    -4.8%

    10.57%13

     

    Average:

    13.2%

     

    Average:

    -5.6%

    11.5%

    Total:

    87,000,000

    98.5%

        

    *as percentage of net assets attributable to common stock. Estimate. Fees and expenses born directly or indirectly by shareholders. Includes Management Fees, Advisory Fees, Interest Expenses, Other Expenses.

    The chart above shows the increasing size and rapid pace of Prospect's secondary offerings in 2011 and 2012. The immediate depreciative effect on share price of the July and November 2012 offerings increased with the size of the offerings. Prospect completed two large secondaries in 2011 and three in 2012, but has held off on initiating any large secondaries in 2013. Prospect has instead continued its equity issuance in 2013 using at-the-market equity offerings.

    At-The-Market and Other Share Issuances

    Since its last large secondary offering on November 1, 2012, Prospect has shifted to issuing equity through at-the-market (ATM) offerings and in portfolio investment deals. Unlike Prospect's large secondaries, its ATM offerings contain a sales load commission fee of about 2% of the offering price, paid to Prospect's ATM sales manager KeyBanc Capital Markets Inc. Instead of an immediate 9% drop in price, as seen after the last secondary, Prospect's regular stock issuance through ATM offerings has held its share price down.

    Other Shares Issued Since Nov. 1st, 2012 Secondary Issuance:

     

    Shares issued

    Type of issuance

    Total Stockholder Transaction Expenses*

    December 13, 2012

    467,928

    Portfolio Investment

     

    December 28, 2012

    897,906

    Portfolio Investment

     

    December 31, 2012

    4,141,547

    Portfolio Investment

     

    January 7 - February 5, 2013

    10,248,051

    ATM Offering

    2.1%14

    February 14 - March 28, 2013

    12,753,216

    ATM Offering

    2.04%15

    April 1 - May 3, 2013

    4,477,037

    ATM Offering

    2.04%16

    May 14 - June 30, 2013

    4,359,200

    ATM Offering

    2.04%

    July 1 - August 21, 2013

    9,818,907

    ATM Offering

    2.04%

    August 23 - October 15, 201317

    18,441,710

    ATM Offering

    2.04%18

    October 15 - November 4, 2013

    9,106,237

    ATM Offering

    2.04%

    Total Shares Issued:

    74,711,739

      

    % Increase in Shares Outstanding:

    36%

      

    *Sales load and other offering expenses.

    Prospect has issued nearly 75 million new shares through alternative stock issuances since its last secondary offering, increasing its supply of stock by an additional 36%.

    Scheduled Future Dilution: Convertibles

    Prospect was the first BDC to issue convertible bonds which convert to Prospect common stock on or before their mature date.16

    Prospect Convertible Bonds12:

    Date issued

    Principal (in thousands)

    Mature on (converts to PSEC shares on or before)

    Number of shares to be issued (at 9/30/13 conversion rate)

    Percent increase in shares (of 9/30/13 shares outstanding)

    12/21/2010

    $150,000

    12/15/2015

    13,221,435

    5%

    2/18/2011

    $167,500

    8/15/2016

    13,155,366

    5%

    4/16/2012

    $130,000

    10/15/2017

    11,195,106

    4%

    8/14/2012

    $200,000

    3/15/2018

    16,572,620

    6%

    12/21/2012

    $200,000

    1/15/2019

    15,955,320

    6%

      

    Average:

    14,019,969

    5%

    Total:

    $847,500

    Total:

    70,099,847

    26%

    From 2010-2012, Prospect issued bonds worth $848 million which begin converting to PSEC common stock in 2015. Prospect has committed to issuing about 14 million shares a year from 2015-2019 through its convertibles. This represents a commitment to a 26% minimum increase of its supply of current shares outstanding through its convertibles, which could exert downward pressure on its share price.

    Conclusion

    Many BDCs have relied on heavy equity issuance in order to raise capital, increase originations and balance debt/equity ratios, a strategy which Prospect Capital Corp. has employed to the greatest extent over the last several years. Prospect's rapid equity issuance, NAV loss over the last year ending September 30, 2013, and tightening yield/fee spread are important indicators to monitor. Our goal has been to measure the effects to date of Prospect' equity-driven strategy on shareholder value.

    Prospect's excessive issuance compared to its peers has contributed to its relatively poor total shareholder return, which we noted in our first report19. Despite lackluster performance indicators, Prospect's rapid asset growth fueled by equity fund-raising methods has benefited management compensation. In a sector where it is difficult to accurately value assets because of lack of disclosure on investments, it remains to be seen how well Prospect's investment of the large amounts of equity capital will perform in the long run.20

    #####

    Prospect Capital Monitor is a website and series of reports by UNITE HERE, the union for hospitality workers in North America. Our 250,000 members are beneficiaries of pension funds with over $60 billion in assets. UNITE HERE analysts regularly distribute information about investment managers in the hospitality industry. UNITE HERE Local 7, based in Baltimore MD, is currently organizing workers whose common landlord, Airmall USA Inc., is 100% owned by Prospect Capital Corp. (NASDAQ, PSEC).

    1BDC list from SEC Business Development Companies Report. Market Capitalization Source: Google Finance. As of 9/19/13.

    2Thomson Reuters Streetevents. PSEC - Q3 2013 Prospect Capital Corp Earnings Conference Call. May 7, 2013.

    3 Grien Robert C. and Jerome S. Romano. TM capital. Middle Market Loan Report Q2 2013. An M&A International Inc. firm.

    4 Prospect Capital Corporation. Form 10-K. Securities and Exchange Commission. For the fiscal year ending June 30, 2011.

    5 Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. August 23, 2013.

    6 Bock, Jonathan and Ronald Jewsikow. Report on Prospect Capital Corp. Wells Fargo Equity Research. November 5, 2013.

    7Prospect Capital Corporation. Prospective Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497(a)(1). October 29, 2012.

    8Gall, Jeffrey. A Strategy For Enhancing Returns With Prospect Capital . Seeking Alpha. February 16, 2013.

    9Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. November 1, 2012.

    10Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. July 10, 2012.

    11Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. February 23, 2012.

    12Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. June 20, 2011.

    13Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. April 4, 2011.

    14 Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497(e). December 21, 2012.

    15 Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497(e). February 11, 2013.

    16Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. May 8, 2013.

    17 Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. October 15, 2013.

    18 Prospect Capital Corporation. Prospectus Supplement. Securities and Exchange Commission, Filed pursuant to Rule 497. August 23, 2013.

    19 Prospect Capital Trails Other Prominent BDCs in Total Shareholder Return. Prospect Capital Monitor, UNITE HERE. October 2013.

    20 Bock, Jonathan and Ronald Jewsikow. Report on Prospect Capital Corp. Wells Fargo Equity Research. November 5, 2013.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Stocks: PSEC, FSC, MAIN, ARCC, AINV, ACAS
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