The stars simply haven't aligned for Prospect Capital (PSEC -1.10%). Falling new originations, declining yields for all BDCs, and the lack of dividend coverage from earnings have sent shares to trade under net asset value.
Net asset value typically provides support for BDC shares, as under this value, investors see an opportunity to essentially buy assets at less than their most-recent quarterly marks.
There is a case to be made that shares could continue to decline, however -- although, of course, no one can predict the future (so they could in fact go up). Here are three reasons why.
1. Negative operating leverage
Operating leverage comes from a company's growing or contracting margins based on growing or contracting top-line revenue.
In most businesses, volume is everything. Many airlines, for instance, can double profits by selling just a few extra seats per flight.
Prospect Capital isn't your typical company, though -- it's an investment company. As such, it isn't a matter of selling more widgets or seats on a plane. Rather, it is the yields it earns on its investments that matter most.
A significant portion of Prospect Capital's costs are fixed. Its borrowing costs are largely set in stone, and its management fee of 2% charged on all assets does not change, regardless if its portfolio yields 6% or 16%.
If yields on middle-market debt investments continue to decline, Prospect Capital's revenue will decline faster than its operating costs. Thus, for each dollar revenue falls, income falls by a greater degree.
Aside from declining spreads seen at all BDCs, Prospect Capital recently restructured many of its majority-owned portfolio companies in a way that would result in lower interest income.
It's largest consumer lender, First Tower, now pays 17% interest on its borrowings from Prospect, down from 20%. Likewise, the company lowered the rate its airline leasing arm, Echelon, pays on its borrowings, from 20% to 14%.
All in all, these moves reduce net investment income to the company. Prospect's management pointed out that it owns equity in many of these companies, and thus the income may flow through as dividends instead of interest, but it remains to be seen whether this will prove true.
On the latest conference call, management noted that in some cases a third-party would have to determine if dividends could be paid to Prospect Capital Corporation from its portfolio companies. Other BDCs have run into similar problems with their equity investments.
2. Loan losses may mount
It's a great time to be a middle-market lender. Liquidity is high. The U.S. economy is expanding, and most companies are making more money today than they were in the past.
But loan losses are not zero. In fact, in the most recent quarter, Prospect Capital lost about $0.11 per share from the bankruptcy of one of its portfolio companies, New Century Transportation. And over the past year the company has recorded roughly $0.13 per share in realized losses from its investments.
Note: The most recent $0.11 per share impairment stemming from New Century Transportation is still marked as an unrealized loss, and is not included in the realized losses of $0.13 per share in the past year.
Over its history, Prospect Capital proved that it can provide a positive return in an economic cycle. However, historical results also show that it is not exactly the best underwriter of the bunch.
Problematic investments strike twice. First, they result in a decline in net asset value. Secondly, the lost NAV impacts the company's ability to generate current income.
3. Its dividend sustainability is questionable
Prospect Capital didn't cover its dividend with earnings in any quarter in 2014. But in most quarters, it was very close to covering its dividend.
By and large, what kept earnings close to the monthly dividend payout were structuring and origination fees -- fees that Prospect Capital Corporation receives for making new investments.
Thus, in order to sustain the dividend, Prospect Capital Corporation had to grow continuously. By issuing new shares, Prospect Capital could make new investments, and generate more one-time structuring and origination fees.
Now that Prospect Capital trades below NAV, generating new structuring and origination fees will prove difficult. I estimate that it can generate $0.06 in fees per share by rotating from low- to higher-yielding investments. This should also add about $0.015 per share in quarterly investment income, using assumptions from a previous article on why shares could have upside.
That isn't enough to make up for the shortfall on an on-going basis, however.
Ultimately, given the decline in middle market loan yields, and Prospect Capital's high cost structure, I think the dividend will have to be cut. And since BDCs are valued as income securities, a lower dividend payment will likely result in a lower share price.
