NEWS

On August 29, 2024 Prospect Capital (PSEC) held its conference call for the calendar IIQ 2024 and fiscal year ended June 2024.

After the prepared remarks, Wells Fargo analyst Finian O’Shea led off the traditional Q&A segment of the call. As we’ll discuss, the call very quickly went south.

ANALYSIS

There were fireworks between Mr O’Shea and the CEO of PSEC (John Barry). Here’s a small example:

John Barry

By the way, why don’t you do the world a favor and do a little research before you come on an earnings call with absurd questions like this? You don’t even know what you’re talking about”.

To be fair, let’s say from the outset that all the brawling, name calling and general bad behavior was coming from Mr Barry. Mr O’Shea remained unflaggingly professional, but dogged in his determination to ask several questions. Most of us might have given up after hearing the first explosive response, but the Wells Fargo analyst soldiered on.

Begin At The Very Beginning

To back up, the bad temper began almost immediately when Mr O’Shea asked the following :

A couple of questions on the preferreds to convertible preferreds to start out. Those conversions picked up this quarter, and we want to see what trends you’re seeing post quarter in those. And second part, the PSEC sort of crisis option as described if the Board determines there’s a risk to 40 Act limitations, ratings, liquidity. Can you describe like under what circumstances you envision the Prospect Board forcing the conversion in all of these? Could it be something as simple as one of the rating agencies or a dividend cut or would it have to be a more onerous liquidity constraint? Thank you.

That set Mr Barry off, who asked “I mean, why are we talking about something like that?”

In Black And White

However, a glance at the 10-K suggests the question is a very legitimate one as this year’s conversion of preferred stock into common stock has been relatively dilutive and is much greater than in prior periods. Two years ago only 69,000 shares of preferred were converted by their holders into PSEC’s common stock. This year the number was 50x higher: 3.3mn shares with a value of $80mn, resulting in 14.1mn new common stock shares being issued. That’s equal to 3.5% of all shares outstanding at the end of FY 2023. For a BDC whose portfolio value and Net Investment Income (NII) have gone nowhere in the past year, dilution is something shareholders need to know about.

Explained Away?

By the way, after all the ranting was done, the BDC’s President did explain that the high level of conversions was due to an investor group in Israel in need of liquidity – suggesting this was a one-time event.

Hypothetically Speaking

The second question was less routine and we wonder what Mr O’Shea expected to be told. He is referring to the fact that PSEC technically has the ability to force the conversion of all outstanding convertible preferred shares into common stock. If that were to occur, and PSEC’s common stock price was low at the time (which it is right now), a huge number of dilutive new shares would be created. (Of course, PSEC would also no longer be required to pay dividends on the preferred either, offsetting much of the additional common stock dividend burden that would occur). This would also wreak havoc with the BDC’s reputation and even its ability to finance itself going forward. (We’re quoting from the 10-K).

Why Would You

This “Issuer’s Option” to buy back its preferred stock with lowly valued common shares is mentioned in the 10-K, which is a repository for every risk imaginable, as per stock market disclosure requirements. However – as Mr Barry made abundantly clear – that’s not an option the Board or the external manager is considering. Nor do we see – and that may be our own shortcoming – how such a move would benefit the PSEC principals. They would lose a key source of capital that is financing the business and would have a great many more shares to contend with, diluting Mr Barry’s very large stock position and – possibly – causing a dividend cut – also not good for Mr Barry. Nor do we see – after all these years – why a rating agency might suddenly turn against this form of financing triggering – in mr O’Shea’s scenario – a decision by the PSEC Board to chuck all its preferred. We must be missing something.

Prosaic

The cooler headed PSEC President gave another reason why the Board would not buy back its preferred:

Related to the preferred, we can’t invoke the issuer option conversion that you mentioned because of our new A4 M4 series and not just the a 5.35% listed preferred. So that doesn’t exist. You’re discussing something in the documents that is legacy and cannot be invoked.

Staying Away

We’re not trained – or untrained – securities lawyers so we can’t say if that’s true from our own trudging through the 10-K, so readers will have to check with their own counsel.

More, More, More

There were further questions – and further rants from Mr Barry in response – about PSEC’s CLOs and its REIT. We won’t go into the substance of the back and forth because of space limitations and because the specific issues raised are not material.

Sharp Contrast

We will say, though, that Mr O’Shea remained cool, calm and professional throughout the Q&A. From our point of view, he has a right to ask any question he deems important without being the target of the sort of bad temper and injurious language Mr Barry directed his way. Also worth noting again is that Mr Eliasek – PSEC’s President – to paraphrase Kipling, kept his head when all about him were losing theirs.

VIEWS

Extraordinary

We’ve been listening to BDC conference calls – or reading the transcripts as in this case – for the better part of 20 years and rarely (we won’t say never) experienced such a maelstrom as this one. We can’t help thinking that Mr Barry might have turned up at the conference call irked about a recent Bloomberg article that had multiple negative things to say. BDCs don’t get much coverage in the wider financial press and when they do it’s usually about negative aspects of the business. We also hear that “short sellers” are taking an interest in the BDC, another factor that may have Mr Barry worried that his very lucrative interest in the management of PSEC might be at risk. (Mr Barry owns over 108mn shares of PSEC while Mr Eliasek less than 2mn, which may account for the fierceness of the former’s response).

Nutshell

The Bloomberg article’s main argument is that PSEC is not generating sufficient CASH income to cover its dividend, even though the $0.06 per share monthly distribution has remained unchanged for years. Instead:

As cash inflows have slowed, Prospect CEO John F. Barry III has resorted to bond and preferred equity sales to individual investors to make up for the shortfall and continue to make dividend payments.

Raising capital is all about investor confidence and should that wane – because of articles like Bloomberg’s or questions like Mr O’Shea’s – Mr Barry might be worried about the knock-on effect on the BDC’s liquidity. (The stock price did drop about (9%) in the wake of the publication of the Bloomberg piece but has mostly recovered since). Whatever the reason, there is no excuse for Mr Barry’s bad behavior which will – ironically – only increase suspicions in some circles that were there’s smoke, there’s fire. The shareholders, though, took it in their stride – the stock is down only (0.4%) today to $5.00.

It’s Not Over

This conference call is now in the history books but we get the feeling that PSEC will remain a controversial BDC. As this chart below shows, the stock price has been in constant decline since 2021 and is trading close to its all-time low, except for a brief period during the Covid crisis and a (43%) discount to its NAVPS. PSEC and its shareholders need something to be done – besides obfuscating by its CEO – to turn things around.