NEWS

Even before Prospect Capital (PSEC) launches its proposed $250mn in “Perpetual Preferred” , the ratings group has assigned a BB rating.  That’s two notches below the current debt ratings for the BDC  “to reflect subordination risk and the risk of deferability of dividends (partial or untimely payment of dividends) on preferred stock“.

That was the rating PSEC anticipated receiving, as reflected in an earlier Prospectus.

ANALYSIS

According to PSEC, the preferred stock will pay a monthly dividend at a fixed annual rate of 5.50% per year. To provide liquidity, the preferred stock holder has the option to convert into common shares at any time, subject to an early conversion fee if the holder converts within five years of the preferred stock’s issuance. Like many retail unsecured debt placements,  the preferred stock allows for optional redemption following the death of a holder, subject to certain limitations.  PSEC has the option to redeem in whole or in part at any time after the five-year anniversary from the issuance date.

S&P, in a press release announcing the new ratings assignment, explained itself in this way:

“We assess this hybrid instrument as having intermediate equity content and therefore will include amounts issued and outstanding in our calculation of adjusted total equity (ATE), subject to a limit of 33% of adjusted common equity (ACE) for all instruments that we have assessed as having intermediate equity content. Our ratings on PSEC reflect its low leverage, favorable funding, scale, and diversified originations. This is partially offset by unfavorable performance in some of its largest investments and relatively high exposure to equity and collateralized loan obligation (CLO) residual interests, which we believe may be more volatile than typical business development company (BDC) investments.

Reported debt to equity was 0.70x as June 30, 2020, and debt to ATE was 0.90x. Our measure of ATE deducts from reported equity investments in subordinated structured notes and equity in finance companies. The company’s unsecured funding leaves the majority of assets unencumbered. Its unsecured debt maturities are well laddered with little refinancing risk because of the modest size of individual maturities and significant undrawn capacity on the revolving credit facility. PSEC’s top five portfolio companies at cost include InterDent and CP Energy Services, which include loans that are on nonaccrual status, and an investment in Pacific World Corp., which has been restructured largely into preferred stock. The negative outlook reflects significant net unrealized depreciation in PSEC’s investment portfolio, including three of its largest investments at cost (CP Energy Services, Pacific World, and United Sporting Cos.) and its portfolio of subordinated structured notes. The negative outlook further reflects proximity to our leverage tolerance for the rating of 1.0x debt to ATE. Over the next 12-24 months, we expect PSEC will manage debt to ATE under 1.0x and maintain ample liquidity. We could lower the ratings if: — We do not expect debt to ATE to remain below 1.0x on a sustained basis; or — Asset quality weakens, in our view, either due to increased losses (realized or unrealized) or rising loans on nonaccrual status. We could revise the outlook to stable if we expect PSEC to maintain debt to ATE below 1.0x and asset quality stabilizes, in our view“.

VIEWS

First Time

As we’ve mentioned before, PSEC is breaking new ground in the BDC sector by issuing a perpetual preferred.

Furthermore, the BDC seems confident of getting the instrument placed at a favorable yield, way below its portfolio yield.

Zig Then Zag

However, it’s important to remember that not so long ago PSEC was putting its hand on its heart and promising not to adopt the SBCAA and maintain debt to equity under 1:1.

That lasted only till the onset of the Covid crisis when shareholders were asked – and duly agreed – to removing that restriction.

Brave New World ?

Now with the Perpetual Preferred we have a strange new situation that is going to take some getting used to.

From a regulatory standpoint the new instrument  will count as debt for purposes of the regulatory debt to equity calculation.

However, the new capital will rank junior even to the existing unsecured notes the BDC has or will issue, as spelled out in the October 30, 2020 Prospectus:

“The AA Shares rank, with respect to the payment of dividends and rights upon liquidation, dissolution or winding up, (a) senior to our common stock, (b) on parity with each other series of our preferred stock, including any series of Preferred Stock, and (c) junior to our existing and future secured and unsecured indebtedness”.

Layer Cake

Effectively, PSEC is creating a three tier liability structure where all other BDCs have two: secured debt followed by unsecured debt.

To that, PSEC is adding this preferred.

Pushed Down

For common stock shareholders that involves some additional risks as the preferred is cumulative and has to be paid in full before common stock shareholders receive their distributions.

The rights of the holders of shares of Preferred Stock rank senior to the rights of the holders of shares of our common stock as to dividends and payments upon liquidation. Unless full cumulative dividends on our shares of Preferred Stock for all past dividend periods have been declared and paid (or set apart for payment), we will not declare or pay dividends with respect to any shares of our common stock for any period. Upon liquidation, dissolution or winding up of the Company, the holders of shares of our Preferred Stock are entitled to receive the Stated Value of $25.00 per share, plus an amount equal to any accumulated, accrued and unpaid dividends at the applicable rate, after provision is made for our senior liabilities, but prior and in preference to any distribution to the holders of shares of our common stock or any other class of our equity securities junior to our Preferred Stock.

Conversion

Furthermore, one of the ways the “perpetual” holders gain liquidity over time is by converting their instrument into common shares based on the most recent 5 day price.

This raises the possibility – or even probability – of an indeterminable amount of common stock dilution as up to $250mn in preferred gets converted to new shares.

For example, at a common stock price of $5.0 a share, 50 million shares would be minted to add to the 373mn already outstanding.

At a $3.0 price, the number of new shares would be 83.3mn and so on.

(Admittedly, PSEC – after year 5 – may pay off any preferred with cash but is not obligated to do so).

Do As You’re Told

The most worrisome aspect of the new Perpetual Preferred is that PSEC has the right to redeem the new instrument for common stock at essentially any time.

This is called the “Issuer Optional Conversion“:

Subject to certain limitations, a share of Preferred Stock may be converted at our option (the “Issuer Optional Conversion”) at any time or from time to time for cash or shares of our common stock upon not less than 30 calendar days nor more than 90 calendar days written notice to the holder prior to the date fixed for conversion thereof. We will settle any Issuer Optional Conversion by paying or delivering, as the case may be, (A) any portion of the IOC Settlement Amount (as defined below) that we elect to pay in cash and (B) a number of shares of our common stock at a conversion rate equal to (1) (a) the IOC Settlement Amount, minus (b) any portion of the IOC Settlement Amount that we elect to pay in cash, divided by (2) the 5-day VWAP, subject to our ability to obtain or maintain any stockholder approval that may be required under the 1940 Act to permit us to sell our common stock below net asset value if the 5-day VWAP represents a discount to our net asset value per share of common stock….

We will not exercise the Issuer Optional Conversion prior to the six month semi-anniversary of the date on which a share of Preferred Stock has been issued (provided that following the listing of Preferred Stock on a national securities exchange, such date shall be the six month semi-anniversary of the first date on which shares of Preferred Stock were issued) unless the Board determines, in its sole discretion, that the conversion of the Preferred Stock is necessary to cause the Company to comply with the asset coverage requirements of the 1940 Act applicable to the Company, to maintain the Company’s status as a RIC, to maintain or enhance one or more of the Company’s credit ratings, to help comply with regulatory or other obligations, to achieve a strategic transaction, or to improve the liquidity position of the Company.

No Choice

From our reading of the above, this suggests that a Perpetual Preferred holder could be required to accept payment in common shares at what could be a very low stock price and for almost any reason.

PSEC shareholders have previously agreed to allow the BDC to sell stock below book value till June 2021.

Below Book

As a result, the BDC could convert the Perpetual Preferred at a common stock price below NAV.

After June 2021, the situation becomes more complex as the conversion may occur at book value, which would be dilutive for existing PSEC shareholders.

This possibility is discussed at length in the Prospectus:

We have obtained stockholder approval under Section 63 of the 1940 Act to issue shares of common stock below net asset value until June 12, 2021. We believe that pursuant to this approval any shares of Preferred Stock issued prior to June 12, 2021 may be converted into shares of common stock pursuant to the Issuer Optional Conversion using the 5-day VWAP to determine the conversion rate at any time, including after June 12, 2021. We believe any shares of Preferred stock issued after June 12, 2021 may be converted into shares of common stock pursuant to the Issuer Optional Conversion using the 5-day VWAP to determine the conversion rate only if we have obtained stockholder approval for the period in which such shares of Preferred Stock were issued and the 5-day VWAP results in a price below net asset value.

The application of Section 63 of the 1940 Act with respect to the conversion of the Preferred Stock under the Issuer Optional Conversion is unclear. It is possible the SEC will assert a position that stockholder approval to issue shares of common stock below net asset value must be obtained for the year in which the Issuer Optional Conversion is exercised, instead of the time at which the Preferred Stock is issued. If the SEC asserted this position and prevailed, we would be required to obtain stockholder approval under the 1940 Act for the years in which we exercise the Issuer Optional Conversion. Obtaining this approval may cause us to incur additional costs and there can be no assurance such stockholder approval will be obtained. If we cannot obtain stockholder approval required by the 1940 Act to issue shares of common stock below net asset value at the time of an Issuer Optional Conversion, then the Issuer Optional Conversion will be effected at a conversion rate equal to:

•	any portion of the IOC Settlement Amount that we elect to pay in cash; and

•	a number of shares of our common stock at a conversion rate equal to (1) (a) the IOC Settlement Amount, minus (b) any portion of the IOC Settlement Amount that we elect to pay in cash, divided by (2) the NAV per share of common stock at the close of business on the business day immediately preceding the date of conversion.

In the event that we exercise an Issuer Optional Conversion with respect to any shares of Preferred Stock, the holder of such Preferred Stock may instead elect a Holder Optional Conversion provided that the date of conversion for such Holder Optional Conversion would occur prior to the date of conversion for the Issuer Optional Conversion.

S&P does not seem to have addressed the issue of Issuer Optional Conversion in its rating.

Understated

The new instrument is going to inject a great deal of uncertainty into PSEC.

It may even be seen as a backdoor way for PSEC – which trades way below book value – to raise equity capital below NAV.

Pencils Out

We suggest any investor in PSEC’s debt, common stock or envisaged Perpetual Preferred familiarize themselves with all the complex details of this ground-breaking – but also potentially onerous – new security.

The BDC Reporter is attaching the October 30, 2020 Prospectus about the Perpetual Preferred to this article.

The legalese is hard to understand at times but we believe we’ve highlighted many of the salient risks.