When Prospect Capital Corporation (NASDAQ: PSEC) announced its plans to spinoff some of its assets into new publicly traded companies, its CEO, John Barry, let it slip that the spinoff would look more like a rights offering than a spinoff. He quickly recanted, suggesting that his use of the phrase "rights offering" was just a general reference to a spinoff. It turns out that it wasn't a misstatement at all -- this is a rights offering in its purest form, not a spinoff.
In a true spinoff, assets are moved from the parent entity to a new entity. Shares in the new entity are then given to shareholders of the parent company for free. In a rights offering, shareholders receive the right to buy shares of stock at a predetermined price. The difference is the price. A spinoff is free. A rights offering is a right to buy more stock, not all that different from a stock option.
Thanks to a recently filed N-2 for Prospect Yield Corporation, which will hold Prospect Capital's highest-yielding assets -- its CLOs -- we now know that this spinoff isn't a spinoff at all. It's a rights offering, so you'll have to "pay to play" if you want shares of the newly spunoff entity.
How it works
When the deal is finalized investors in Prospect Capital Corporation will receive rights entitling them to buy a proportionate amount of shares in Prospect Yield Corporation. We don't know how much of its CLOs it intends to "spin off" via a rights offering -- it's probably something less than all of its CLOs based on its conference call commentary and the language of the new SEC filing -- but we can use an example to understand what it might look like.
At the end of Dec. 31, 2014, Prospect Capital Corporation had a net asset value of $10.35 per share. Of that, CLO investments accounted for $3.13 per share.
Thus, in a rights offering, Prospect Capital could give you a right to purchase one share of Prospect Yield Corporation for every Prospect Capital Corporation share you own. The rights could entitle you to buy a share of Prospect Yield Corporation for their stated net asset value of $3.13 each.
This would have the effect of being NAV and leverage neutral, a goal Prospect Capital outlined in previous conference calls. You pay $3.13 for your shares of Prospect Yield, which flows to Prospect Capital. Prospect Capital sends CLO investments it values at $3.13 per share to Prospect Yield Corporation.
Thus, in the end, Prospect Capital Corporation has the same $10.35 in net asset value, with cash taking the place of its CLOs, and Prospect Yield Corporation has a NAV of $3.13 in CLOs for a combined value of $13.48. Net effect: You put more money to work to own a slice of the new "spinoff," Prospect Yield Corporation.
This is just my expected base case for what the rights offering will look like. Part of the difficulty in making any projections with Prospect Capital is management's habit of making intentionally opaque comments, in my opinion. For example, do terms like "NAV neutral" or "leverage neutral" apply only to Prospect Capital, or the combination of Prospect Capital and Prospect Yield? Frankly, there's no way to know. But working with only what shareholders have in hand today, I think the above is a good base case for the actual mechanics of the rights offering.
Why I think it's a raw deal
It seems shareholders aren't exactly getting fair treatment from the rights offering, for several reasons:
- You have to commit more money to Prospect Capital to participate in the rights offering. Otherwise, your only recourse is to sell your rights at the market price, which might be lower than their "fair" valuation. If Prospect Capital gives you a right to purchase Prospect Yield Corporation with a net asset value of $3.13 for $2.80 each, your rights should technically be worth $0.33 each. But it's possible that the rights won't trade for full value.
- There are serious questions about the true value of Prospect Capital's CLO investments. If you participate in the rights offering, it's likely that you're paying an above-market price for its CLOs.
- A rights offering is a taxable event. Whether or not you exercise your rights, it's likely that you'll owe a tax on the rights you receive. I'd recommend you do what the filing suggests and speak to a tax accountant about the actual impact. I find it likely that the rights will allow you to buy Prospect Yield Corporation at a discount to its net asset value, with the difference treated as a "dividend" of sorts. Refer back to the example in item 1, where Prospect Capital gives you the right to buy Prospect Yield for $2.80, below its net asset value of $3.13.
Given the above, I see this rights offering as a way for Prospect Capital to dump its CLOs at an above-market price to its existing shareholders, create desperately needed liquidity at Prospect Capital Corporation, and generate more fee-earning assets for its external manager, which is seemingly the only beneficiary of a rights offering vs. a true spinoff.
