Prospect Capital: Dividends, Not Capital Gains

Don't bank on capital gains to add to your total return. Prospect Capital's convertible shares and at-the-market stock sales hold down share prices, restricting gains.

Apr 16, 2014 at 11:20AM

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Photo: LendingMemo.com.

Business development companies are a mixed bag of investment potential. Some BDCs seek to provide income in the form of dividends, and capital gains from a rising share price.

Others, however, focus primarily on yields. A company like Prospect Capital (NASDAQ:PSEC) fits in the yield category, and thus investors should expect only limited capital gains.

Here's why Prospect investors should bank on yields, not capital gains.

1. Convertible debt
Prospect Capital has a history of funding its balance sheet with longer-term debt, not short-term bank financing. This debt is largely raised with the issuance of institutional convertible notes, which can be swapped for stock at the conversion rate.

A recent filing shows that a block of 2015 notes is convertible at $11.23 per share. If shares trade above the conversion price, the debt can be swapped for stock.

These share sales aren't dilutive, as they're well above the last-reported NAV of $10.73 per share, but they do constrain the share price, as new shares will be issued when share prices are above the conversion rate.

2. At-the-market sales
Prospect Capital monetizes its shares when they trade over net asset value, even by modest amounts. This quarter, even though Prospect Capital trades very close to its last net asset value, it filed a new shelf registration to issue up to 20 million new shares for immediate sale on the market at Prospect's request.

Historically, new share issuance has cost Prospect Capital about 1% of the total amount raised. When shares are sold at a 1%-2% premium to book value, as they are now, there is very little accretive benefit after accounting for the cost of issuing stock.

Prospect Capital's filing for a new shelf registration at a time its shares trade at only a very modest premium to book value showcases Prospect's willingness to grow at any price.

Most BDCs issue shares with costlier, one-time secondary offerings, which require larger spreads between the market price and net asset value to be accretive to shareholders, providing more upside potential from capital gains before the next secondary offering.

Bottom line
Does it matter? In a word, yes. First, capital gains are taxed very differently from income. Secondly, it's important to know where the upside comes from when buying any stock, whether it's a dividend aristocrat or a business development company.

Prospect Capital management frequently notes that its shares trade at a higher yield and lower multiple of earnings than other BDCs. But as long as the company monetizes its share price premiums immediately with new share issuance, share prices will have very little room to run higher.  

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Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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