Friday, January 18, 2013: Fast growing Prospect Capital (NASDAQ:PSEC) today announced the closing of a number of real estate loan transactions, and a commitment to funding more as the opportunity arises. The press release indicates 3 industrial and multi family loans have been booked to date, but Prospect is interested "in all types of direct and indirect real estate investments, including properties owned by private equity-owned companies". The booked loans amount to under $50mn, a tiny proportion of the Company's overall loan portfolio. However, the Company clearly has big ambitions, as they have set up a de-consolidated real estate investment trust called APH Property Holdings.
We have a few comments on this major development from Prospect, a company that we have invested in on and off for several years, and which has a history of idiosyncratic corporate behavior (remember Prospect trying to wrest away Allied Capital from Ares Capital ?).
First, the move appears to presage a long term move into asset management, akin to what American Capital (NASDAQ:ACAS) has been successfully doing in the mortgage space with two public Real Estate Investment Trusts ("REITs"). The establishment of the non-consolidated subsidiary may only be driven by tax considerations, but could also allow Prospect to ultimately spin off real estate to the public in an IPO. Of course, if properly conducted that could be a plus for Prospect's earnings in the long term.
Second, there are many unanswered issues relating to the economics of this new venture. No details have been given about what yields are to be expected from these real estate loans. Prospect's regular lending activity to PE backed companies achieves double digit yields. Will yields in R.E. compare ? We doubt it. Moreover, we don't know if this new subsidiary will be leveraged and how ? We also don't know what the cost to Prospect's shareholders in terms of the management fee and incentive fee will work. We can assume that any amount invested in the REIT will continue to incur the 2% management fee, but we cannot be sure.
Third, from a long term credit standpoint, we have to worry until proven otherwise, about a BDC getting into a very different type of lending several years into an economic expansion (i.e. when values have moved up). We remember that the afore mentioned Allied Capital made a similar foray into real estate investing back in the pre-Great Recession period. The press release does not tell us if Prospect has engaged the services of experienced real estate lenders or is relying on it's existing lender team.
Fourth, and on a related note, we're a little surprised by the manner in which Prospect has chosen to proceed with this initiative. We may be wrong, but we don't remember any mention by management of wanting to be in the real estate business (but it may be buried in one of the numerous equity prospectuses the Company seems to release almost daily). We also don't know if investing in real estate is really within the spirit of what Business Development Companies are supposed to be doing. If Prospect was a hedge fund, we'd call this "style drift".
Anyway, in the short run, the new R.E. initiative should have little impact on portfolio mix or earnings. We'd be surprised if real estate moved the needle through all of 2013, which gives investors time to evaluate where we're going. If anything, today's news provides a useful insight into management's strategic vision and approach to shareholder communication. The former, as we said earlier, remains idiosyncratic and unproven. The latter is opaque, so investors need to be unduly vigilant or you'll wake up one day to find you've invested in a very different company than you thought you did.
Disclosure: I am long PSEC.
Additional disclosure: We are also Long Prospect Capital's public Notes trading under ticker PRY.