Prospect Capital Corp. (NASDAQ:PSEC) is one of the largest business development companies on the market today. For better or worse, it has grown its balance sheet much faster than its rivals. When you grow fast, you have to find places to put money to work quickly.
That rapid fast growth has made Prospect Capital one of the most diversified companies in its industry. It owns real estate and "peer-to-peer" loans, and has a beefy book of high-yield collateralized loan obligations, all on top of the usual items such as debt and equity investments in private, nonfinancial businesses.
Management believe the company's shares are the victim of a complexity discount. That is, investors might like one or two of its businesses, but perhaps not all of them, so they aren't willing to invest in Prospect Capital as it exists today. Maybe if investors could pick and choose which investments they like -- real estate, CLOs, or the P2P loans -- then the pieces might trade for a higher price than the complicated mix of investments Prospect Capital now owns.
That's the logic behind Prospect Capital's plan to spin off its assets into four distinct pieces. When all is said and done, Prospect Capital shareholders could own as many as four different stocks, backed by its collateralized loan obligations, peer-to-peer loans, real estate, and everything else that gets left behind in Prospect Capital Corp.
But I'd argue a spinoff and the resulting increase in shareholder value is anything but in the bag. In particular, two things could ultimately impact whether this is a winning proposition for shareholders.
1. Will the earnings add up?
One company will almost always have lower operating costs as a percentage of assets than four companies. Think about it -- four companies require four auditors, four corporate boards, four credit facilities, four insurance contracts, four listing fees, etc.
In fact, there is a strong link between scale and expenses for BDCs. Most BDCs find that their operating expenses as a percentage of assets fall quickly as assets grow to $1 billion-$1.5 billion. Beyond that, the marginal impact of another dollar in assets tends to be pretty small.
Given that Prospect Capital's spinoffs will invariably be sized at less than $1 billion each, I believe the additional operating expenses could reduce potential dividends and earnings when all the pieces are added up.
The only way I see this being offset is if the spun-off companies get better terms in their management agreements than Prospect Capital has with its external manager. That does not seem like a high-probability outcome, but it's possible.
2. Will it be NAV neutral?
There is a big stink about completing the spinoffs in a way that is NAV neutral. That means doing it in a way that 100% of Prospect Capital's current book value is reflected in the book value of its pieces when broken up. Where the pennies per share fall in each entity is hardly certain, but the point is that a $1 of book value in one entity today should be reflected in full with $1 of book value in the sum of its parts.
What's the risk here?
So far, the plan has been to raise new capital with the spinoffs. Thus, in addition to shares that are given or sold to its existing shareholders, Prospect Capital wants to bring new shareholders on for the ride, too.
Suppose Prospect Capital spins off the entirety of its P2P loan book, which the company recently valued at $248 million, or roughly $0.69 per Prospect Capital share.
In addition to this spinoff, suppose it seeks to sell an equal number of new shares to new investors at a slight discount, say $0.61 each, to raise new capital. The net result is that the new spinoff would have a per-share book value of $0.65 per share, made up of loans and newly raised cash.
So, $0.69 of book value per share leaves Prospect Capital. In exchange, you now own a new P2P loan company with a book value of $0.65 per share, made up of P2P loans and cash. Add it up and you lost out -- you got diluted by about $0.04 per share thanks to the dilutive capital raise at the time of the spin.
Can Prospect Capital do that? Sure. Will it? Well, it hasn't been definitively ruled out.
When asked during the company's latest earnings call if the spinoffs would be NAV neutral, COO Grier Eliasek said, "Well, that's our objective. ... But as always, the objective has to be measured against what happens from a regulatory and market feedback aspect."
Market feedback is another way of saying the plan to raise capital is inevitably tied to what the market is willing to pay when new capital is raised. If the market wants to pay only 90% of book value for newly spun-off shares, then that just might be the price at which it raises new capital; therefore, the spinoff would negatively impact book value and presumably earnings when the pieces are added up.
Keep in mind that using the P2P loan book as an example understates the potential impact of dilutive equity issuance at the time of the spinoff. The company's online lending assets are the smallest of the assets slated to be spun off. The CLOs, which admittedly might not be entirely spun out, make up a sixth of total assets, and even more as a percentage of net assets.
Why not simplicity?
Spinoffs do not inherently create value, particularly if they happen alongside dilutive capital raises or if increases in operating costs offset the perceived value of "pure-play" assets versus a "conglomeration" of assets.
There is also the matter of opportunity costs -- instead of spinoffs, what if Prospect Capital merely sold off some of its assets for cash, and bought back stock at a current 15% discount to book value? Dealing in probabilities, an asset sale and stock repurchase would almost certainly increase book value and earnings on a per-share basis. The value creation from spinoffs is anything but clear.
But management has decided to take this route. Investors are just along for the ride.