Prospect Capital's (NASDAQ:PSEC) management team just helped itself to $600,000, and it came directly out of shareholders' pockets.
Here's how management did it, and why shareholders should be outraged.
Fees from thin air
This quarter, Prospect Capital sold its stake in airport retailer AirMall at a realized loss of roughly $3.5 million. Prospect reported that it received net proceeds of roughly $51.4 million, which included a $3 million structuring fee.
Curious people are left to wonder why Prospect Capital structured this deal in this fashion. Why sell Airmall for $48.4 million plus $3 million in fees? Why not just sell it for $51.4 million flat?
KBW analyst Greg Mason asked precisely this question on the company's conference call:
One final question not related to the spin, you exited Airmall, which you own. It looks like you said you took a $3.5 million realized loss on the exit and a $3 million structuring fee on the exit. Given that you own the whole thing, what was your thought process of taking the structuring fee but realizing the loss versus just kind of just exiting it at no significant gain or loss without the structuring fee?
Grier Eliasek, the business development company's COO, offered this answer: "Well, we did not hire an investment bank to market that asset, and our team at Prospect did an enormous amount of work to source an international buyer -- a European buyer -- for that asset. So that was a fully earned fee."
In short, the fee exists because Prospect Capital worked as the investment banker on the deal. That makes some sense. But Prospect owned 98% of the company. It is basically paying itself a fee. That doesn't make much sense.
Prospect Capital CEO John Barry then opined on the call that there is no economic difference between a price plus a fee and just a pure price in an asset sale.
Mason countered that in this case there was an economic difference to the tune of $600,000: "I would say there is slight economic loss to shareholders though given the 20% incentive fee on the structuring fee versus would be none if it was just -- the realized loss did not occur."
Fees vs. capital gains and losses
You might think $51.4 million in income is just that, no matter what form it takes. That is true for most companies. But for externally managed companies such as Prospect Capital, not all income is created equal.
The external manager would have earned nothing from the sale of AirMall if it were simply sold at a flat price, with no structuring fee involved. It can't take a capital gains incentive fee on a capital loss, nor should it.
However, by transferring some of the total price of AirMall into a "structuring fee," the external manager boosts Prospect Capital's net investment income, and thus the size of its income incentive fee. It can bill shareholders for 20% ($600,000) of the $3 million structuring fee.
Squeezing shareholders a nickel and dime at a time
Let me be clear: Prospect Capital's external manager is entitled to fees. It should earn its 2-and-20 fees as permitted by the contract between the management company and Prospect Capital.
It should not, however, go out of its way to structure deals in a way that enriches the external manager at the expense of shareholders. That's exactly what we have here.
Any reasonable person would be right to think that its 2-and-20-style fees (which are the highest in its industry, by the way) would more than cover the occasional cost of selling a company from the portfolio. The same reasonable person might conclude that the capital gains incentive fee works the way it does to compensate management for investment exits at good prices, not just any price, particularly prices below its original investment.
So when the management team shuffles money around to create fees it otherwise should not earn, shareholders have the right to be upset. Ultimately, though, it's not just about the $600,000, it's about whether this management team has the best interests of shareholders in mind.