Prospect Capital Corporation's Smart Tax Strategy

Prospect Capital Corporation uses debt in its controlled buyouts to eliminate taxes at the corporate level. Here's its president's and COO's take on structuring investments with debt or equity for tax efficiency.

Jul 25, 2014 at 1:59PM

Business Development Companies like Prospect Capital Corporation (NASDAQ:PSEC) can own controlled companies. But how they structure these buyouts has huge tax implications. Debt can help reduce taxes. Equity, on the other hand, provides tax-efficiency for the shareholder base when it comes to capital gains.

In the following video, Motley Fool Financials Bureau Chief David Hanson and Fool contributor Jordan Wathen ask Grier Eliasek, Prospect Capital's president and COO, Grier Eliasek, about the company's tax strategy. Additionally, the Fools seek some rationale behind Prospect Capital's heavy use of debt investments.

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A transcript follows the video. 

Wathen: Then finally, just to round it out here with a quick question on deal structuring -- is there advantage to structuring these buyouts with more equity to generate capital gains, or is there advantage to structuring it with more debt?

I know historically you have structured a lot of these investments with more debt than equity, and I was just curious to hear your take on that.

Eliasek: When we buy a company in a one-stop manner, where we supply a majority of the equity and debt, our desire is to do so tax efficiently. We do not want to under-leverage these businesses to result in tax leakage for shareholders.

We also want to be prudent about how much we pay for these businesses, so we can continue to generate an attractive yield for our investors. Many of our buyouts have been completed at only around 5x cash flow, which is not much more than a lending multiple in today's market. Ideally, we therefore get the equity for free, or close to free, which gives us upside in the business.

From an investor measurement perspective, our observation is that public company investors strongly prefer recurring income streams to lumpy capital gains for their base return, so we expect to continue to structure our control deals in this manner.

If any of these companies should do tremendously well -- and we are evaluating multiple companies in our book today for potential exit -- we would of course also generate a tax-efficient capital gain for our investors, so we like to have our cake and eat it, too.

Wathen: Right, so rather than have the portfolio company pay taxes, you can insert enough debt to where you take the income out through the debt, without having it come through the equity? You're saying you basically minimize taxes at the portfolio company level?

Eliasek: Correct. Also, we're able to pledge those types of loans to our credit facility, get to borrow against them; a number of benefits.

Key in all this is not to overpay for a company. If you overpay for a company, whatever amount of debt you might slap on it, if the company can't service the debt -- and that's pretty clear; we put companies on non-accrual if it can't pay its contracted obligations within 60 days -- there's really no way of getting around it.

If we stick to the rules of not overpaying the companies that we're buying, and not over levering the companies that we're lending money to, that we're not buying, then we're going to be in very good shape, indeed.

Hanson: I've got one more question for you, and then we'll finish up here. If you were investing in one soccer team to win the World Cup, what are you picking right now?

Eliasek: Well, I'm an American, right?

Hanson: That's the right answer!

Eliasek: I'm going to pick with my heart, rather than my head. Go Team U.S.A.!

Hanson: All right, that's what we like to hear. Grier, we really appreciate you taking the time to talk with us today -- really insightful stuff -- so thank you very much.

Eliasek: David and Jordan, I really appreciate your time and hospitality on this show. Terrific, thank you.

Hanson: Thanks.

Wathen: Thanks.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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