I briefly mentioned in my previous article an appropriate valuation model for PSEC.
In this article, I present a basic framework from which we can begin to construct a model to project Prospect Capital Corporation's (NASDAQ:PSEC) fair value, broken down into three key aspects. Each aspect of this framework merits its own individual discussion, and so for that reason, I will break this up into several articles.
A Basic Framework
To value PSEC, we are mostly concerned with its future cash flows. I break this down into three basic questions that we must ask in order to compute a fair value for PSEC.
- What are PSEC's future cash flows? In other words, its total investment income?
- Out of this total investment income, what portion will be distributed to investors? This is equivalent to asking what portion will go towards management fees and expenses.
- What sort of returns do investors in PSEC expect? In other words, what is an appropriate discount rate?
Today, I seek to answer the second question. Specifically, given X amount of total investment income, what portion will go to PSEC advisors and what portion will remain for investors?
Adam Smith writes in his Wealth of Nations:
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.
It is a line that most of you have probably heard, but often times fail to apply. Its meaning is quite simple - a rational individual acts in his or her own best interest. And to apply this to PSEC, we must then consider that John Barry and Co. are neither good nor evil, merely rational individuals acting in their own best interests. For them, this would mean maximizing their utility by increasing their income through management fees while avoiding the negative utility of litigation or SEC inquiry. In plain English, they wish to make as much money as possible while still being bound by fee agreements, laws, and regulations.
PSEC's Current Fee Structure
Before we dive further into this, I wanted to summarize PSEC's Fee structure. The full details can be found in its SEC filings here. I have read several comments from users on Seeking Alpha that would indicate a lack of understanding of the fee structure, and so, I hope this section clears up any misunderstandings.
The management fee paid to PSEC advisor's each year (paid quarterly) is broken down into three components. These are:
- Base Management Fee: 2.00% of gross assets
- Incentive Fee: 20% of ordinary income with an 8.75% hurdle. Ordinary income is computed as the total investment income, net of all expenses, and the base management fee but not including capital gains (or losses). The fact that it does not account for capital losses is a sore point among investors, but that is a discussion best saved for another time. The ordinary income percentage is taken as the ordinary income divided by the net asset value. Lastly, the hurdle works as follows. Investors get 100% of the first 7.00% of ordinary income. 100% of anything from 7.00% to 8.75% goes to the advisors, known as a "catch-up". Beyond that, advisors take 20%.
- Capital Gains: 20% of capital gains (which will likely never happen, and so I won't bother to discuss it).
How Does Barry Maximize his Earnings?
Firstly, you must accept that due to the subjective nature of valuing investments that don't have an observable market value, Barry has quite a bit of room to manipulate the numbers on the books to meet his needs, especially if he needs to adjust down.
Now, your first intuition should be obvious. Barry wants to maximize his gross assets to maximize his base management fee. But there is a second key takeaway from the fee structure that we must also consider, and this is the "catch-up". Barry gets to keep 100% of any income from 7.00% and 8.75%. If Barry inflates his gross assets too high, the income to NAV ratio will drop and start cutting into this "catch-up" segment. At this point, further inflation to the gross assets will be akin to bending over a dollar to pick up a dime - the lost incentive fee far surpasses the additional base management fee from increased gross assets. And so, Barry will always try to collect the full "catch-up" segment of the incentive fee.
Let me illustrate this with a numerical example:
We assume that PSEC maintains 1.7 times leverage ratio for our calculations. Suppose that ordinary income currently sits at 7.00% of NAV. At this level, Barry gets 0 incentive fee. His base incentive fee would be 2.00% of gross assets, which is 1.7 times the NAV.
- Base = 0.02 x (1.7 x NAV) = 0.034 x NAV
- Incentive = 0
- Total = Base + Incentive = 0.034 x NAV
Barry is missing that juicy incentive bonus, so how can he capture it? Well, if NAV were to decline 20%, ordinary income would then be: (Note: NAV here denotes the original NAV).
(0.07 x NAV) / (0.80 x NAV) = 0.0875 x NAV - bingo!
And so, Barry's incentive fee would be a full 1.75% of the new NAV. What would happen to base fee? It would now be 2.00% of the reduced gross assets, which due to leverage constraints would be 1.7 x (0.80 x NAV).
- Base = 0.02 x (1.70 x (0.80 x NAV)) = 0.0272 x NAV
- Incentive = 0.0175 x (0.80 x NAV) = 0.0140
- Total = Base + Incentive = 0.0412 x NAV
As you can see in this example, by reducing the NAV, Barry has effectively increased the amount of fees that he collects by roughly 21.2%.
The implications of this are as such:
- Since Barry will always go for the "catch-up", investors must therefore expect at minimum, 7.00% of the NAV in distributable NII.
- Furthermore, as the ordinary income to NAV ratio continues to decline, we will likely begin to see distributable NII converge to 7.00% of NAV.
- NAV will be bounded on the low end, by PSEC's total investment income (TII) and on the high end by Barry's ability to inflate the books. Mainly, it will be a function of TII such that NAV is at least 8.75% of TII. And so given TII, we should be able to project the NAV, and thus, future dividends.
Be on the lookout for my next article, in which I will discuss risk premium and investor's expected return on PSEC (i.e. discount rates).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.