NEWS

On November 8, 2024, Prospect Capital (PSEC) announced its results for the IIIQ 2024. Here is an extract of a summary from Seeking Alpha:

Prospect Capital (NASDAQ:PSEC) stock dropped 6.8% in Friday premarket trading after the company cut its distribution to common shareholders by 25% as it rotates structure credit collateralized loan obligation (“CLO”) equity and real estate investments into its core business of first lien senior secured middle market loans. Meanwhile, fiscal Q1 earnings topped the consensus estimate.

The business development company declared monthly distributions of $0.045 per common share for November, December, and January, down from its previous distribution of $0.06 per common share in October.

“CLO equity has decreased to 6% of our assets (versus 18% as of September 30, 2017) as we execute on our rotation strategy to emphasize first lien senior secured lending, with such mix growing significantly for us,” said Chairman and CEO John Barry. “CLO equity typically generates attractive cash-on-cash yields, but such yields tend to be higher in the initial years while lower in the later years, thereby resulting in variability that we seek to dampen by focusing more on our core business at Prospect Capital Corp. (NASDAQ:PSEC)”

The company expects that another fund managed by an affiliate of Prospect Capital Management LP will focus on new CLO equity investments, with less targeted PSEC balance sheet investment in the strategy.

Fiscal Q1 net investment income per common share of $0.21, vs. the Visible Alpha consensus of $0.17, fell from $0.25 in the prior quarter and $0.31 a year ago.

For the full press release, click here.

ANALYSIS

As always

We’re fond of predicting before every earnings season that chances are very high – based on twenty years of watching the public BDC market – that one or more BDCs will “flame out” – for want of a more financial term in the period.

This quarter, we’d gone without the clear-cut quarterly missteps that have occurred in previous periods at TriplePoint Venture Growth (TPVG); BlackRock TCP (TCPC – last quarter’s winner in this category – Horizon Technology Finance (HRZN); OFS Capital (OFS) and others.

In fact, TPBG, HRZN and TCPC all seem to have stopped the bleeding in the IIIQ 2024, but that’s a subject for another time.

Here We Go

We were beginning to believe this quarter was going to be the exception to the rule where BDC setbacks was concerned till we read the PSEC press release announcing both a “rightsizing [of the] common shareholder distribution rate” and a new business strategy going forward.

The dividend cut is huge: (25%) and made all the larger by the fact that PSEC was unable during the 2022-24 period of high interest rates to raise its payout to shareholders.

This, coincidentally, came on a day, when the BDC Reporter noted in the BDC Publications News Feed that Saratoga Investment (SAR) has managed to increase its annual payout by 82% between 2021 and 2024 – boosted by a just announced $0.35 end of year “special”.

New Approach

Going forward, PSEC – as spelled out in its press release and to a greater extent on its conference call – is changing strategies.

After years of being heavily invested in CLO equity (generally a no-no where BDCs are concerned) and in real-estate (a rare asset on BDC balance sheets), the goal is to divest itself of those assets.

Also – and harder to identify – management wants to sell off “successful middle market deals where we also hold equity”. We imagine the BDC is referring to “Control” investments where PSEC has the right to direct an exit and harvest any equity upside.

Presumably, this means companies First Tower Finance which PSEC lists as having equity with a cost of $31mn and a FMV of $189mn. The BDC essentially owns most of the shares.

First Tower Holdings of Delaware LLC (“First Tower Delaware”), a consolidated entity in which we own 100% of the membership interests, owns 80.10% of the voting interest and 78.06% of the fully-diluted economic interest of First Tower Finance Company LLC (“First Tower Finance”). First Tower Finance owns 100% of First Tower, LLC, the operating company.

We count 5 “Control” companies where there is a substantial unrealized appreciation of PSEC’s equity, including First Tower but not including the BDC’s REIT, which has a cost of $1.1bn and an FMV of $1.6bn.

Charge!

Curiously, as interest rates rose from 2021, PSEC doubled down – literally – on its investment at cost in the REIT, going from $589mn in debt and equity to $1.117bn currently.

The equity value, though, did not keep up. At the end of 2021 PSEC valued its equity stake at $637mn. As of September 30, 2024, the equity is marked at $533mn. Presumably, further depreciation might be possible.

Back To The Middle

PSEC’s “new” strategy is to focus more on “middle market” lending. On its conference call, management repeatedly made clear this was not syndicated loans, but direct lending to companies to which the BDC would provide debt and equity.

The opportunity was described in luminous terms on the conference calls, presumably to educate anybody listening not familiar with this segment of leveraged lending:

…Such core business with proprietary opportunity flow offers higher spreads than lending to much larger companies which loans are experiencing significant spread compression for other lenders focused on that more competitive and commoditized larger end of the market.

Middle market loans, by comparison, offer higher interest rate floors, often 250 to 400 basis points versus loans to larger companies which often have only 0 to 100 basis point floors, thereby providing better protection for yield and income when short-term interest rates decline. Such higher floors benefited Prospect Capital Corporation greatly when the Fed last sharply reduced such rates during the GFC.

… With such core business middle market investments, we also sometimes have an opportunity to structure investments with equity upside, including through warrants, convertible debt and 2x liquidation preferences, with an objective to maximize current yields and total returns in a prudent and risk-adjusted fashion.

Many such investments that we are currently underwriting have targeted un-levered double-digit current yields and un-levered total returns of 12% to 15% or more. With such yields and total returns further enhanced by our credit facility to lift targeted levered returns to 18% to 20% or more.

PSEC – IIIQ 2024 Conference Calls

Middle-ish

Every BDC – like politicians talking about “the middle class” – defines “middle market” differently. For the record, PSEC’s current portfolio of loans has a weighted average EBITDA per portfolio company of $105 million.

By our definition, that size company would be called Upper Middle Market (UMM). The Middle Market (MM), ore typically, would be composed of companies generating an EBITDA of $25mn to $50mn, or even up to $75mn. When the EBITDA gets higher, companies can readily tap the syndicated market where borrowing rates are much lower – for the right business.

From our experience we find that the sponsors acquiring $100mn+ EBITDA companies do not tend to permit their lenders to acquire a material equity co-investment nor are interest rate floors anywhere near the levels mnentioned. A range of 100-150 basis points is what we’re accustomed to see.

Timeframe

PSEC did not give any sort of timetable for this portfolio re-positioning so – at this time – we can’t say if this will take a matters of months or years.

Management did confide that neither the market for CLO equity investments nor real estate are particularly attractive right now.

PSEC’s Net Asset Value Per Share dropped (7.3%) this quarter and has dropped (24%) since 2021. Unless the BDC gets very lucky or has drastically under-valued the investments to be sold, that could mean further book value erosion is possible. However, that was not discussed on the conference call.

VIEWS

Let’s Get Real

Notwithstanding the apology on the conference call by CEO John Barry to Wells Fargo analyst Finian O’Shea about the heated words he used on the prior conclave, we were disappointed – as always – by the absence of much truth telling either in the PSEC press release or conference call.

There was no admission that the strategy of investing in CLO equity – famous for paying high yields initially but being followed by much depreciation in value – was wrong headed from the start.

Nor was there any concession that investing in real estate – by definition a very illiquid investment and very affected by the interest rate cycle – might not have been the best idea for a public BDC.

To Heck With The “Little Guy”

Nor were there any words of remorse to the BDC’s legions of small investors for cutting their distributions by (25%) after many years of keeping their distributions unchanged while almost all their peers were increasing their payouts.

In the last 3 years, those shareholders have also seen their stock price drop in half and generate a (13%) total return.

Yet, management, which paid itself close to a quarter of a billion dollars in compensation in recent years, offered no waiver pr permanent cut to its management or incentive fees, which are the highest of any in the public BDC space.

No Safe Harbor

Nor is this intended shift in strategy much more than a reversion to the original BDC model of lending to middle market which PSEC has veered from on multiple occasions (remember their big push into energy when that sector was hot?) and almost always without success.

Neither PSEC nor its shareholders should expect to find easy pickings in the middle market – however defined – going forward.

As all our readers will know, there are plenty of lenders already active – both BDCs and others – and at the moment a dearth of new deals, bringing down pricing and pressuring terms.

Most of the “new deals” done in recent quarters have been add-on acquisitions for existing borrowers.

Nor is PSEC’s credit track record in this segment anything to write home about.

By doubling down in the middle market, will PSEC be able to nab quality transactions or might they end up with an above-average level of marginal deals?

Long Time

Unfortunately for investors, the proof of the pudding typically takes a few years to show up.

This likely means we have several years – somewhere between 3 and 7 – to see if PSEC 2.0 will be a success.

Given the very high losses of capital to date; the BDC’s less than stellar reputation; its high cost of borrowing on a secured basis, and many other factors, that seems very unlikely.

Last Word

In reality, management might primarily taking these steps to position the BDC – or at least its portfolio – to be acquired by a third party in the future.

With the CLOs, the real estate, the “control” investments loaded up with PIK, out of the way, PSEC might find a buyer.

That would not take as much time as a full facelift for the BDC.

If we do see some fee concessions down the road that may be a signal that the owner of the external manager has an exit plan in mind.

We emphasize that this is but a theory.

Another Reason To Subscribe

In any case, the next few quarters will prove to be interesting as the portfolio changes and the economics of the BDC are transformed.

Unfortunately, investors should continue to take everything said by the principals with a great deal of salt or face the risk of even more disappointments than they have already.