Prospect Capital Corporation Earnings Take an Interesting Turn

Prospect Capital (NASDAQ: PSEC  ) reported earnings yesterday, but all eyes are on a few particular items in the company's recent filings.

The quarterly report reveals that the SEC may require Prospect Capital to restate its historical financials to account for its operating companies.

The specifics
Prospect Capital is chock-full of operating companies -- companies in which it owns a majority stake. Normally, the financial results of majority-owned, or "control" companies would have to be included in the financials of the public company.

For example, Prospect Capital owns First Tower, one of its biggest operating companies. Because it holds 100% ownership of a holding company that owns 80.1% of the operating company, the financials for First Tower and other majority-owned companies, the SEC argues, should be included in the financials at Prospect Capital.

Right now, Prospect Capital does not consolidate the results from First Tower in its own financials. Instead, First Tower maintains its own balance sheet. What insight we have into a company like First Tower is limited to the disclosures in the company's SEC filings. The recent quarterly report shows third-party debt, total assets at First Tower, and finance receivables (First Tower loans to customers), but not fully fledged financials.

Does it matter?
Yes, for two reasons.

First, Prospect Capital management noted on the conference call that it had previously recorded more interest and fee income from its operating companies than the operating companies earned. They insist that their focus remains on cash flow, and thus, so long as cash flow covers cash paid back to Prospect by their operating companies, there shouldn't be a problem.

If consolidated, however, Prospect Capital would only be able to report a portfolio company's reported net income in any given quarter. Since the companies' net income has been historically lower than the amount of interest and dividends paid to Prospect Capital, restated earnings would be lower.

Secondly, there's the issue of leverage. BDCs are limited to 1:1 leverage. Should the financials of its operating companies be consolidated into Prospect Capital's results, Prospect Capital will have significantly higher debt levels than reported today. In First Tower's case, there is roughly $272 million of additional, third-party debt that would have to be reported on the Prospect Capital balance sheet, which could affect its required 1:1 leverage limit imposed on BDCs.

The dizzying world of BDC accounting
The complexities of the current accounting methodologies make it difficult to understand the true profitability of Prospect Capital's operating companies.

This quarter, Nationwide Acceptance and Credit Central, two of Prospect Capital's operating companies, paid Prospect Capital dividends of $5 million and $2 million respectively. However, this same quarter, Prospect Capital invested a combined $6.5 million in the two companies.

The accounting as it exists today makes this a bit of a shell game to those looking in from the outside. Prospect loaned its portfolio companies $5.525 million, added $975,000 in equity, then paid itself dividends of $7 million.

Said another way, $6.5 million left Prospect Capital to go to Nationwide Acceptance and Credit Central. Then, $7 million came back to Prospect Capital (on the income statement) as a dividend. Of course, there are adjustments to the equity valuations likely as a result of the dividends paid, but the impact is murky at best.

Equity is valued with "unobservable inputs," and any adjustment to expected future business volumes, a change in unknown discount rates, or movement in default rates on Nationwide Acceptance and Credit Central's loan book, etc. could have just as much effect on the equity line as a dividend. 

Prospect Capital is appealing the SEC's request to consolidate its financials, so for now, it's just one giant waiting game.

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  • Report this Comment On May 07, 2014, at 6:06 PM, houston321 wrote:

    You state that if psec must consolidate the portfolio co, then they (psec) can only report the portfolio co's net income, which is usually less than the interest they paid to psec on the loans. However if the interest paid to psec is un-reportable as an interest expense, then it must stay within the portfolio co. and flow to the bottom line, thus increasing portfolio net income by the same amount. The cash flow was generated and it went somewhere, it cannot disappear into thin air. It's either an expense to portfolio co, or adds to portfolio net income. Thus psec management insisting that it makes no economic difference, only accounting difference.

  • Report this Comment On May 07, 2014, at 6:52 PM, jmkdog wrote:

    "If consolidated, however, Prospect Capital would only be able to report a portfolio company's reported net income in any given quarter. Since the companies' net income has been historically lower than the amount of interest and dividends paid to Prospect Capital, restated earnings would be lower"

    This is not at all the case. From the conference call this was discussed.

    Earnings would be higher, NAV higher and distributions higher.

    Yes the holding company would either be eliminated or consolidated in a control investment.

    Currently absorbing all third party debt would not be cause for alarm because you would book income which would offset much of the debt.

    This simply changes the structured buyouts through a holding company.

    The cash yield of the CLO book is 22% what is reported under GAAP is 15-16%. They would move this 700 bps to income.

    Listen to the call, it was said at least 6 times

    1. NAV goes up

    2.taxable earnings up

    3.incentive fees down

    4.Prospect management fee up

    Is the 3rd party company servicing the debt out of profits or out of cash flow, I think it is more likely "Cash Flow"

  • Report this Comment On May 07, 2014, at 10:29 PM, Jon408 wrote:

    Why do the MF writers never respond to comments? It would be interesting to see the reasoning here on these issues.

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