Prospect Capital: The Enemy Within

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John F. Barry III, the founder, chairman and chief executive of business development company Prospect Capital in Manhattan, 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 percent 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 Screen Shot 2016-08-03 at 2.07.45 PM

The Southern Investigative Reporting Foundation 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 cutoff before or after a quarter’s end, the foundation removed 10 instances of trades done at appreciably different pricing levels but as much as three months after a reporting period.)

For example, in an April 13 email given 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 percent of par value. Prospect, per its 10-Q, valued this CLO at 66 percent 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 1 or 2 percentage points of the winner — for $2.45 million of the CIFC Funding 2013-III CLO was 43.5 percent; Prospect valued the same CLO at 67 percent 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 percent or to sell the same amount at 65 percent. On Dec. 31, Prospect marked this at 80.4 percent.

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, counseled 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.”

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Prospect’s shareholders might not have seen the “nasty, brutish and short” fate described in Thomas Hobbes’ Leviathan, but some do have a fair measure of resentment that’s perfectly understandable.

That’s due to Prospect management’s compensation framework, which virtually guarantees that fees grow if total assets under management expands. Based on a management fee of 2 percent of gross assets and an incentive fee of 20 percent, 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 his or her 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 noncash inputs, preventing the company from investing that cash elsewhere.

Last year 8.4 percent of interest income, or more than $29.2 million, was attributable to PIK.

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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 long time. I stand by our reporting on what [we] obtained from the SEC under the Freedom of Information Act.”

In a March release discussing the 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. The 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.

Editor’s note: A family member of the author owns Prospect shares in an investment account but did not trade the security before the release of this report.

2 thoughts on “Prospect Capital: The Enemy Within

  1. I paid $11 for PSEC a couple of years ago. It was a disastrous investment the the year following that move, but has been making a decent comeback, although I’m still down overall, but not too badly given the monthly dividends received over that time.

  2. I got in at $6.00needlessto ay im happy but nervous. whats your take on the recent spike up?

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