Business development companies are often described as "black boxes" because they hold hard-to-value assets, many of which do not have a liquid market to determine their value. Prospect Capital Corp. (NASDAQ:PSEC), one of the largest, is no exception.
It is one of a handful of BDCs that invest in CLO equity, dedicating an outsized 17.2% of net assets to the asset class. Collateralized loan obligation equity can be described as a leveraged bet on corporate loans.
Loans are assembled, matched with cheap leverage, then the remaining slice -- the equity -- gets the remainder of the cash flows when all other investors are paid off. Prospect's CLO investments are primarily in CLO equity -- the highest-risk, but highest-return slices of CLOs.
On its most recent conference call, there were pointed questions about whether its CLO equity investments are appropriately valued.
Wells Fargo (NYSE:WFC) saw CLO equity trading at a 6%-8% discount during the quarter. Prospect Capital's CLO equity is currently marked at a 4.7% premium to its cost basis.
That kind of difference tends to raise eyebrows. With the topic up for discussion, I think it's important for investors to understand how Prospect Capital values its CLOs, and why investors are taking a closer look at its portfolio marks.
Giving value to its CLO equity positions
Prospect Capital values its CLO investments by discounting their expected future cash flows back to the present. The rate at which it discounts these cash flows ultimately has a large impact on a CLO's reported value.
Its financial filings reveal that there has been a significant change in the valuation inputs on its CLO equity from quarter to quarter, and since June 30, 2014.
It currently discounts expected cash flows back at a weighted-average rate of 13.2%, down from a weighted-average rate of 14.9% for the quarter ended September 2014, and 16.8% as of June 30, 2014.
All else equal, a lower discount rate produces a higher valuation for an asset. Thus, as discount rates go down, asset values go up.
The chart below is an illustration of how the valuation of a series of cash flows changes based on what appear to be relatively small movements in a discount rate. (It is not meant to be representative of CLOs, but an illustration of how a lower discount rate impacts valuation.)
Had Prospect Capital held its discount rates constant from June 30 or Sept. 30, 2014, its CLOs would necessarily be marked at a lower value than they were on Dec. 31, 2014. That's just how the math works. And while the composition of its CLO portfolio changed from quarter to quarter, reasonable people are left to wonder if it's appropriate to hold CLOs at prices above their cost basis when the market implies CLOs are trading at a discount.
This is the point of contention surrounding its CLO equity values as of year-end 2014. With other CLOs trading at discounts, and with sales of its own CLO equity during the quarter at discounts to their fair values and cost basis, there is some evidence to suggest that its CLOs may be carried at a higher valuation than what they would sell for today.
How big or small of an unwarranted premium is a curious matter. Wells Fargo's Jon Bock implied CLOs were trading at a 6%-8% haircut. If you merely reduced Prospect Capital's reported fair values for its CLO equity by 6%-8%, it would reduce net asset value by 1.8% to 2.5% at the bottom and top of the range. Net asset value would be $10.10-$10.17 per share compared to $10.35 as of December 31, 2014.
And while that may seem insignificant, it would have the effect of putting Prospect Capital's results more in line with its peers, which have, so far, largely reported net losses for the fourth quarter, when gains or losses on investments are included.
Is Prospect Capital the calendar fourth quarter outlier it purports to be? I think reasonable people are right to have their questions.