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?
[drizzle]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 were sold into the market. Based on a survey of the conference-call transcripts of other BDC’s who buy CLO equity, only Prospect is making this argument.
Put another way, it doesn’t make economic sense to break apart something that cost $25 when the sum of its parts is worth $23.50. As of the end of the March quarter, according to Wells Fargo’s Bock, 23 of Prospect’s 38 CLOs had negative NAVs.
To see whether Prospect’s CLO equity valuations have reflected prevailing market values, the Southern Investigative Reporting Foundation used trade level indications and bid-list data provided by investment-banks active in the CLO market. In two instances the public filings of Prospect’s rival BDCs were used. To make the process as fair as possible, only trades made within 30 days before or after a quarter’s end were included.
The chart below represents our estimate of this valuation differential.
We found 13 instances where Prospect’s marks differed sharply from the prices other investors were paying for them. This differential started at the end of 2014 and, in aggregate, suggest that management was able to avoid at least $83 million in portfolio value reductions. (In imposing a 30-day cut-off before or after a quarter’s end, we removed 10 instances of trades being done at appreciably different pricing levels but which had been done up to three months after a reporting period.)
For example, in an April 13 email given to the Southern Investigative Reporting Foundation, a CLO trader told clients that a customer was offering a block of between $5- and $10 million of a Prospect owned CLO tranche, Symphony CLO IX Ltd., at 54% of par value. Prospect, per its 10-Q, valued this CLO at 66% as of March 31.
In another instance, on March 22, a broker emailed his clients that the cover bid—the second-place bid in a “Bid Wanted in Competition” auction, usually within one or two percentage points of the winner—for $2.45 million of the CIFC Funding 2013-III CLO was 43.5%; Prospect valued the same CLO at 67% on March 31.
Last December, a brokerage made a two-way market in the Octagon Investment Partners XV, Ltd. equity tranche, offering via email to buy $5 million at 62% or to sell the same amount at 65%. At December 31, Prospect marked this at 80.4%
It’s a Wall Street truism that an asset is worth only what someone will pay for it, so with a well-established CLO secondary market–even conceding that CLO equity is the least-liquid in its asset class–it would appear logical to use market inputs when pricing.
It’s not so clear cut, counsels Mark Adelson, editor of the Journal of Structured Finance and a 20-year veteran of securitized product analysis. Speaking generally, Adelson said that while trade prices are ordinarily a valuation’s primary component, CLO equity’s spotty liquidity means that at least some tranches won’t trade enough and that the theoretical inputs of models are required.
“We’re talking about Level II and III assets here. Trades are very meaningful but there is a risk that the buyer was an idiot, so you can’t turn your back on the model.”
“Then again,” Adelson said, “If you have the ability to discern whether the buyer was [sophisticated] and the markets were orderly, your model needs to reflect those trades.”
The lot of Prospect’s shareholders haven’t seen the “Nasty, brutish and short” fate of mankind in Thomas Hobbes’ Leviathan, but is they have a fair measure of resentment that’s perfectly understandable.
That’s due to Prospect’s management’s compensation framework, which virtually guarantees that fees grow if total assets under management expands. Based on a management fee of 2% of gross assets and an incentive fee of 20%, last year Prospect Capital paid Prospect Capital Management–the John Barry-controlled advisory managing its investments–over $225.3 million and the year prior it was almost $198.3 million. An additional $21.9 million was paid to Prospect Administration, the entity set-up to manage the BDC’s non-portfolio operations, for a total of just under $247.2 million.
(Privately-held, Prospect Capital Management isn’t obliged to disclose what Prospect Capital’s key executives earn.)
On the other hand, Prospect’s shareholders, who have experienced two dividend cuts since 2010 and over 75.8 million of share sold below net asset value, are stuck with this chart.
According to a shareholder lawsuit filed in April in U.S. District Court that is alleging a breach of fiduciary duty against Prospect Capital Management and Prospect Administration, shareholders were inappropriately charged between $54 million and $102 million, depriving shareholders of increased dividends. (In June, Prospect filed a memorandum of law in support of a motion to dismiss.)
To be sure, there’s nothing wrong with a CEO wanting their company to grow, and handsomely compensating those who generate increased profits is exactly how the system should work. To that end, Prospect has indeed grown its profits, reporting $346.3 million in net income from 2011’s $94.2 million.
Yet Prospect’s filings suggest that these figures are less a function of shrewd lending choices than they are of a great deal of dilution and burgeoning debt. Consider that in June of 2011 Prospect had 107.6 million shares outstanding and $406.7 million in long-term debt; five-years later those totals now stand at 356.1 million and more than $2.95 billion.
When Prospect’s investors tire of mercurial portfolio growth and want higher dividends, they might take a hard look at how they compensate management. Because management is rewarded for growing interest income, rather than on how well the borrower performs, over $1 billion of loans have a Payment-in-Kind component, where a proportion of an interest payment is made in securities. This increases the net interest income figure, but the benefit is on paper since it brings in no cash. Management, to be sure, gets paid in cash based off a formulation that includes non-cash inputs, preventing the company from investing that cash elsewhere.
Last year 8.4% of interest income, or more than $29.2 million, was attributable to PIK.
Prospect hasn’t taken the criticism lying down.
CEO John Barry referred to criticisms of Prospect’s business model and accounting as “a smear campaign” this February during a conference call. In December, general counsel Joseph Ferraro wrote a series of letters to Seeking Alpha angrily denouncing Probes Reporter, an institutional research provider whose specialty is using freedom of information act requests to determine if companies are fully disclosing Securities and Exchange Commission investigations, for having written that the company was not being forthcoming about a purported investigation.
Probes Reporter chief executive John Gavin, in a brief interview said, “I’ve been doing this for a longtime. I stand by our reporting on what [we] obtained from the SEC under the freedom of information act.”
In its March release discussing their dispute with Prospect, Gavin argued that the company had more success with three critical articles published in The Motley Fool last August and September by contributor Jordan Wathen, which no longer appear on its website. Asked to confirm whether the company was behind their removal, Wathen declined comment. Motley Fool did not respond to an email seeking comment.
The only comment given to the Southern Investigative Reporting Foundation about Prospect and its affairs was John Barry’s curt “Are you really calling me at home” when contacted at his home, followed by “Put [your questions] in an email.” Several follow-up calls and emails were ignored.
(A brief word of disclosure: A family member of mine owns Prospect’s shares in an investment account and didn’t trade the security before the release of this report.)
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