Prospect Capital Corporation: How and Why It Grows

Prospect Capital Corporation (PSEC -1.10%) isn't a bank. It cannot retain earnings. Therefore, growing the balance sheet requires that the company issue new shares to the public.

Motley Fool Financials Bureau Chief David Hanson and Fool contributor Jordan Wathen recently sat down to speak with Grier Eliasek, president and COO of Prospect Capital, about how it grows its balance sheet with stock issuance.

A transcript follows the video below.

Hanson: Yes, we've been talking about the debt portfolio and some of the companies in that portfolio, like First Tower. But you mentioned earlier that Prospect also takes equity positions in these companies that they're investing in, and that can be one of the ways that shareholders see upside in terms of net asset value increasing as the equity investments increase in value as well.

Prospect suspended their ATM share program for the time being, I would guess. Is it safe to say that growing the balance sheet with equity is kind of off the table, since shares are trading below that NAV now?

Eliasek: Well, that is safe to say. As we discussed on prior earnings calls, Prospect is not keen on issuing shares below NAV. We did not file a new ATM program, given where we are trading. We're currently at a discount to net asset value with an over 12% dividend yield.

We think the current trading has a lot to do with the rebalancing of the Russell equity indices. As some of your viewers might be aware, the Russell indices recently removed BDCs -- these are the broad-scale equity indices -- because of a nonsensical technical regulatory rule.

The overall stock market has been hitting record highs, but BDCs in the last several months have underperformed the market because of this Russell rebalancing. The good news is, the Russell rebalancing will be complete next Friday, June 27, which thereby removes this technical overhang, so many out there are arguing that now is an excellent entry point for BDCs like Prospect Capital.

Wathen: As we think about Prospect growing its balance sheet -- obviously, as a BDC, you have to raise equity capital to do so, or raise debt capital, but obviously that's limited to the regulatory limits.

I was thinking, as you're growing, how do you weigh the payoff between issuing new shares and investing in, say, lower-yielding assets -- so your future investments may be lower-yield than the investments that you have on the books now -- how do you weigh when to issue shares and when not to?

Eliasek: Well, it's pretty straightforward. We're not interested in issuing shares below net asset value. Above net asset value, we may look to issue shares, hopefully at as large a premium as possible, based on what we're seeing with demand for our capital in the private marketplace.

We have a focus, given our large team, proprietary deal flow, and diversified origination strategy, on -- and it sounds trite -- but we try to make money in every year of the economic cycle, instead of just some years.

In the current environment, we are turning down low-quality companies and over-leveraged capital structures, but we're still finding attractive opportunities. In the March quarter we put on the books about $1.4 billion in gross originations, which was a record total for us. We're pleased with that output, and even more pleased with the credit quality of our portfolio which, as of the last quarter, had delivered a low 0.3% cumulative default rate.

Remember that our loans are generally five years at inception but typically pay off in two to three years, so we aren't taking long-term risk as a lender. We are looking to rotate out of lower-yielding situations, including a senior loan initiative that we announced recently to sell lower-yielding loans off the balance sheet, into probably some type of managed account structure, that would allow us then to rotate into higher-yielding situations.

Those types of strategic decisions are how we're dealing with potential yield compression in the marketplace.