Prospect Capital: The Enemy Within by Roddy Boyd
John F. Barry III, the founder, chairman and chief executive of Prospect Capital, a Manhattan-based business development company, can’t seem to get any respect.
In June 2015 Prospect took out an advertisement in Barron’s that sought to attract more investors by touting its then 12.4% dividend yield and the share price promptly dropped. A shareholder wrote a tongue-in-cheek essay calling Prospect “The most hated stock on Wall Street.” Over the past six months both the Wall Street Journal and New York Times have written critically–to varying degrees–about the company’s portfolio valuation and dividend payment practices. Not to be outdone, short-sellers, who have had the company in their sights for nearly five-years, are broadcasting their own list of grievances about Prospect’s operational and accounting disclosures. Posts about the company or its prospects go up on Seeking Alpha nearly weekly and attract dozens of commenters who weigh in with full-throat for days at a time.
Incredibly, a Well Fargo research analyst has even gone so far as to issue a “Sell” recommendation on its shares.
Why does a company with under a $3-billion market capitalization arouse the passion usually reserved for disputes over so-called battleground stocks like Herbalife or Tesla Motors?
One reason for the intense feelings is attributable to Prospect’s corporate structure as a business development company, an unusual hybrid of commercial lender and investment fund. At bottom, it’s a federally-chartered closed-end fund required to invest at least 70% of its assets in the debt or equity of small- and medium-sized companies and distribute 90% or more of its income to investors. Because of this, a large percentage of BDC investors are attracted by the dividends; in Prospect’s case, the $1 monthly dividend gives its shares just over a 12% current yield.
But BDCs also have limits on their ability to pay dividends if the debt-to-equity ratio goes above 100%. At quarter’s end on March 31, Prospect’s ratio was 73.8%. A BDC not paying dividends would be hard pressed to retain many investors.
There’s a precedent for this kind of fight and it’s the stuff of Wall Street legend: Greenlight Capital’s David Einhorn waged a bitter multi-year struggle against Allied Capital, a BDC that he sold short in 2002 because of what he said were numerous financial irregularities. While Allied eventually was sold to a competitor in 2010 at a fraction of its peak market capitalization, the many millions of dollars of expense Greenlight incurred made it a Pyrrhic victory. (In an ironic twist, shortly before its sale, Allied caustically rejected an unsolicited merger bid from Prospect.)
Based on a Southern Investigative Reporting Foundation investigation into Prospect’s $1.1 billion book of collateralized loan obligation investments, it appears that investor concerns over valuations are well-placed. Then again, the risks to shareholders from incorporating market prices into their CLO portfolio are much less than management’s dexterity with esoteric accounting maneuvers.
Recall that CLOs are special purpose vehicles whose various sections, known as tranches in Wall Street parlance, are fixed-income securities made up of corporate loans. The CLO’s principal and interest is paid from its highest-rated, or most senior, tranches on down; credit losses are absorbed from the bottom up, with the unrated piece–the “equity”–bearing both the CLO’s highest interest-rate and absorbing all of its initial credit write-downs. (The CLO’s higher-rated tranches can change hands with frequency but the liquidity of an equity deal is often spotty.)
BDCs like Prospect find CLOs attractive because from a risk perspective, they offer a diversified pool of loans that is higher in the capital structure than corporate debt, enabling them to get paid back first if a default were to happen. Prospect and several rival BDCs have built extensive CLO equity portfolios because given the nature of their structure, the equity tranches can target 12%-15% annual returns.
Prospect’s approach to valuing its CLO book has been a source of sustained controversy for the company.
Critics like Wells Fargo research analyst Jonathan Bock, who issued the “Sell” rating in April discussed above, argue Prospect’s peers have shown little hesitation in reducing the value of similarly constructed CLO equity portfolios. He compared Prospect to Eagle Point Credit and highlighted the then 21-point spread between the two: at the end of last year, Eagle Point’s CLO book was valued at 55.6% of its estimated fair value while Prospect marked it at 76.3%.
While an imperfect comparison, that 20.7% percentage point differential between the two portfolios illustrated the point that the stakes are very real, representing a notional $230 million hit to Prospect’s equity value and the loss of millions of dollars in fee income for its management.
For its part, Prospect has said that it has no control over the actual portfolio valuation process since it’s done under contract by Gifford Fong Associates, a California fixed-income analytics consultancy. It’s an unusual choice: Gifford Fong certainly has an established practice in financial theory and mortgage-backed securities pricing, but based on numerous calls to CLO trading desks and investment-managers, no one had heard of it being used to provide pricing. (With no centralized exchange, price discovery in the $881 billion CLO market is usually done using broker-dealer pricing services.)
Fong did not respond to a pair of phone messages and an email.
Nor has Prospect’s management done itself many favors in communicating how it arrives at its valuations, often seeking to redirect questions into discussions about the importance of being the CLO equity market’s biggest investor or the top-ranked collateral managers who structure and issue the deals they buy.
A question during Prospect’s second quarter conference call last year is illustrative of Prospect’s roundabout way of addressing CLO valuation questions.
On February 5, 2015 Raymond James Financial analyst Robert Dodd asked president and chief operating officer Michael (Grier) Eliasek why four CLOs were sold for losses after being carried on the books at a premium to their acquisition price: “So I mean was there something particularly problematic about these that changed from the end of September to the period when you sold…And I mean is there something we should read into that as to the overall book being marked above par when we’ve got the four most recent cases…all marked above par?”
In response, Eliasek said: “I would not read too much into that, Robert, there [are a] few other dynamics at play here,” before discussing how Prospect was in a position to “throw its weight around” and obtain original issue discounts and rebates, which were something that didn’t “travel with the deal” if they sold the paper in the market.
(To be sure, having a lower cost basis than your competitors often makes an investment incrementally more profitable, but it doesn’t speak to portfolio valuations.)
Prospect’s management also argues that having what they term a “call right,” where their status as the majority investor in an equity tranche gives them the ability to compel the distribution of the underlying loans to investors, should justify a premium valuation.
But it’s not apparent this is currently applicable given what’s known as “negative net asset value,” where the cost of the equity tranches exceeds fair value, or the estimated price they’d get if they