This Dividend Stock Isn't Done Growing -- Yet

One of the biggest BDCs has no plan to slow its growth spree yet.

Jan 16, 2014 at 10:40AM

Business development companies have been on a growth spree. One in particular, Prospect Capital (NASDAQ:PSEC), has been growing handily with the help of multihundred-million-dollar acquisitions.

The company recently put out a press release that all but guarantees it isn't done growing yet.

Bigger funding potential
When it comes to running a BDC, it's all about how you can borrow cheaply to invest profitably. Prospect Capital announced it had increased one of its funding sources -- a credit facility -- from $650 million to $1 billion.

Ordinarily, a larger credit facility is a mundane, boring part of corporate finance. But when a serial acquirer increases its credit line -- the limit on which it can cash a check -- it's big news.

Why it matters
Credit facilities are the most senior of any loan or debt. The lenders in the facility expect to be paid back first, and in almost every case, the credit facility has its own collateral.

This is the case at Prospect Capital. Prior to increasing its facility to $1 billion, Prospect had the option to borrow up to $650 million total from a number of national banks. Backing its potential borrowings were some $884.3 million in assets -- debt and equity investments it owned in its portfolio.

Collateral helps the borrower (Prospect, in this case) get better terms, like lower interest rates. However, it also creates unique risks, especially in a credit crunch. Let's not forget that rival BDC American Capital Ltd. (NASDAQ:ACAS) got itself in trouble with credit facilities and overborrowing in 2008 and 2009. American Capital had borrowed big, backed the borrowings with collateral, and nearly lost it all when it failed to keep within the terms of its agreements.

You see, if a borrower fails to keep up with certain limits known as covenants, lenders can force the borrower to sell the collateral and repay the borrowed funds immediately. In a credit crunch like 2008 and 2009, American Capital had to sell assets at far less than they were worth in a normal economic environment to make good on its promises at the time. In essence, it was selling dollar bills for $0.50 to repay lenders.

Why you should watch carefully
Prospect Capital's press release is thin, but if it increased its facility up to $1 billion, one would also expect the collateral backing the facility to have grown from its original $884.3 million in size.

One way to measure BDC riskiness is to look at a BDC's so-called "unencumbered assets," or assets that are not pledged as collateral to its borrowings. Prospect Capital managers have historically lamented their high-level of unencumbered assets as a unique asset. I tend to agree with management, here -- the more money Prospect Capital can borrow without collateral, the better the position of equity investors. The increased limit is, to me, a sign Prospect Capital will continue growing the balance sheet.

A colossal rainy day fund
All in all, an increased credit facility is good news. On numerous conference calls (most recently, the fiscal fourth-quarter call), Prospect CEO John Barry describes its credit availability as something like a rainy day fund. When the next credit cycle hits, Prospect Capital will have up to $1 billion on which it can draw to snap up underperforming assets.

The facility gives it leverage to make big, accretive deals, or swallow up a whole lender, as it did when it acquired the remaining assets of Patriot Capital during the credit crisis. Going back through the most recent filings, I can't find a time when Prospect Capital used a significant chunk of its credit facility for routine, day-to-day financing needs. It really is a rainy day fund, indeed.

Prospect Capital managers deserve credit for their foresight. Though middle-market lending is performing particularly well, it won't forever. And when that happens, Prospect Capital is making sure it has ample credit to ride through a storm. The small annual cost to keep the facility available is relatively nonexistent, and the benefits of having a credit line during a credit crunch are massive. To build on its facility in a strong lending environment in anticipation of eventual weakness is a very smart move.

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Fool contributor 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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