Prospect Capital Lawsuit Really Not A Big Deal

| About: Prospect Capital (PSEC)

Summary

Current lawsuit really doesn't mean much for shareholders.

PSEC's excessive management fees are already factored into the price.

There is no chance for the stock price to drop further as a result of management fees.

PSEC's management is getting sued - oh no. By this point, most of you have seen and read this recent SEC filing and without going too much into it, the suit basically reads "PSEC's management fees are too damn high".

But what does this actually mean for shareholders??

In my opinion, not much, and certainly not a reason to sell as suggested by some other authors and commentors on SA. Lets take a look at a some possible outcome scenarios for this lawsuit.

Suit is dismissed or drags on indefinitely and we return to status quo - This is more than likely the outcome of this lawsuit as there is not enough substantive evidence to suggest that PSEC has fraudulently manipulated the books in order to increase their management fees. Even in the off-chance that the lawsuit can put forward some compelling evidence, PSEC management has the resources to drag this on indefinitely. For shareholders, this outcome will mean PSEC spending 1, 5 maybe even 10 million dollars of shareholder money on legal fees. So at 355 million outstanding shares, shareholders suffer a net loss of around a penny a share and maybe at worst 3 cents per share.

Defendant is ordered to reduce management fees - While this outcome seems highly unlikely it's not one I would complain about as a shareholder. Borrowing some numbers from this article here, if PSEC's management collected 225.4MM in fees last year and we cut that even 1/3 thats approximately 70MM or nearly 20 cents per share in cost reduction. Where does that money end up? Right in shareholders' pockets along with any penalty awarded since the proceeds of any successful action are awarded to the corporation and not the initiator of the suit. In other words, shareholders have a very good day.

Now let's talk about management fees

Lets start with a very concrete example. Lets assume we have two BDCs which are entirely equal in all aspects save for the management fee. And lets further assume that we know for certain the market will be stable and that neither BDC will dissolve anytime in the near future.

Which of these two stocks would you prefer? A or B? Oh wait, that's right! we can't make that call until we know the current share price of both A and B.

Of course since A has higher fees than B it is worth less, but that doesn't mean B is a better buy. If B is selling at $15.00 a share and A is selling at $5.00 a share I'm LONG A ALL DAY.

Point being, true, true, true, PSEC's fees are pretty high. But that doesn't mean PSEC is a bad investment, because this information must be taken into account relative to price. In fact this logic should be applied to just about all equity investments. "The key," as Warren Buffet puts it, "is the price it is selling for now compared to what it's worth".

Management fees are a tangible, easily calculable and predictable cost of business. Not only is the fee structure clearly laid out for investors, there is also a quarterly report detailing the fees paid to management. There is really little room for speculation when it comes to fees and as such management fees can easily be priced into a stock. To argue that a stock's price will change in the future based on what is already known and determined is complete nonsense.

The only way that management fees can tank the stock is if PSEC's management were to raise the fees unexpectedly. Given the current legal climate they're in, I feel comfortable saying the odds of that happening are pretty much zero.

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.

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