Prospect Capital (PSEC 1.30%) recently reported earnings, but a plan to spin off new companies from its existing assets stole the show.
Analysts peppered its management team with questions on the conference call, and the back-and-forth exchanges offered a good opportunity to get a better understanding of the Prospect Capital business. Here are five things you should know.
1. Why Prospect issues shares under book value
It was certain to come up: Prospect Capital has recently raised money by selling shares under book value, drawing criticism for diluting investors' holdings.
President and COO Grier Eliasek explained the rationale behind the move: "As we disclosed in our release, we have an additional condition precedence pertaining to allowable advances on our credit facility, which basically you can think of it as an equity raise requirement in order to fully draw on the facilitating financing.'
Later, CEO John Barry added, "You need to calculate when $1 of stock frees up $1 of capacity in our credit facility -- you have to give credit for that."
Management seemed to suggest that without an equity raise, Prospect Capital would not have been able to use its entire credit facility. At the time of its earnings release, the business development company carried just over $20 million on its $810 million facility. Over its history, Prospect has rarely been a heavy user of its credit facility. Some questions remain, and since the conference call, Prospect Capital filed to sell up to 50 million more shares even as the stock trades at a big discount to net asset value.
2. How Prospect Capital covered its dividend this quarter
Prospect Capital hasn't covered its dividend with net investment income in quite some time, not even this quarter. But net investment income isn't everything. In reality, its dividend is based on taxable income, which only loosely tracks net investment income.
This quarter, Prospect Capital reported $0.44 per share in taxable income, roughly $0.11 per share more than dividends paid this quarter. Where did the excess come from? Brian Oswald, the company's CFO, explained how an insurance payout became taxable income:
AerLift received some insurance proceeds from a plane. It gets a little complicated, because a lot of tax depreciation and stuff comes in to play, but the answer is that at AerLift it actually generated a gain, because it had been depreciated significantly from the original purchase price of the plane.
AerLift Leasing is owned by Echelon, Prospect Capital's aircraft leasing company. In reality, AerLift is basically the entirety of the aircraft leasing company, but let's not split hairs.
AerLift owned Malaysia Airlines Flight 17, which was shot down in July over Ukraine, killing nearly 300 passengers and crew members. The company received an insurance settlement for the loss, and the money was paid back to Echelon. That money was recorded as income, because of the difference between the plane's accounting value and the value of the insurance settlement.
This "income" was really from an asset sale. It's not repeatable going forward. And you wouldn't want it to be. It's the equivalent of liquidating assets and paying dividends with the proceeds -- and no one wants to make money from airline crashes.
3. Why Prospect Capital is spinning off assets
Eliasek noted that the primary driver of a spin-off was to get a higher multiple on the company's different business lines:
Why not put that into another structure where you can potentially command a higher pure play multiple, which of course is the logic of why a company might examine spinoffs in the first place. So that's what we are trying to achieve and that's really the first and largest compelling reason.
Prospect Capital believes its peer-to-peer lending assets, collateralized loan obligations, and real estate holdings aren't as attractive when combined with its larger middle-market lending business. Thus, the idea is to break these businesses up into four parts: peer-to-peer, CLO, real estate, and the traditional Prospect Capital business.
The idea is that "pure plays" will collect higher multiples of earnings and book value than they do within the existing structure.
4. Details of the spin-off will be few and far between
More so than other business development companies, Prospect Capital's management seems to spend a lot of time worrying about its competitors. Executives noted several times that they intend to closely guard details of the spin-offs, hoping not to help out Prospect's rivals.
Barry explained his firm's silence on the issue:
Here's what's happened a lot of times. We come up with an innovation at Prospect and people copy it right away. So we are very mindful not to give all of the crown jewels away on this call. I'm speaking very plainly. When we did the first covert in this industry in December 2010 people ripped off our documents and copied it after we spent years doing this paperwork to get the regulatory approval and ripped it off within three weeks.
I'm not entirely sure why this is a focus for Prospect, or if it really matters that its competitors imitate its financing moves. But what is clear is that Prospect Capital probably won't give much more information about the spin-offs until they happen in "early 2015."
5. On the company's CLO strategy
Prospect Capital has done quite well in collateralized loan obligations, earning cash returns that frequently top 20% annually.
Cash returns are often higher than generally accepted accounting principles returns, because Prospect Capital invests in the CLO equity.
Eliasek provided an excellent example of how this works:
Apidos VIII...a deal we called a year ago with cash returns north of 32% IRR. When we printed that deal a couple of years prior, it was I think during one of the European mini flash crashes. Spreads had widened. Your liability costs were actually much higher than they are today, but they booked very well and because we were able to buy assets at a steep discount. The deal benefited substantially from a pull to par strategy of those loans then trading back to par.
In short, this Apidos VIII CLO, like all other CLOs, earned money based on the spread between its borrowing costs and its yields on the pile of underlying loans. However, because it was formed at a time of panic about Europe, many of the loans bought for the CLO were purchased at discounts. For example, the CLO might have purchased loans for $0.90 per dollar of face value.
When fear subsided, the loans traded closer to par value, Prospect Capital exercised its right to call the CLO as a major equity owner. Thus, the loans were sold, lenders to the CLO were repaid, and Prospect Capital kept the remaining capital. The result was a 32% internal rate of return in an area where 15-20% IRRs would be superb.
