Prospect Capital: Highlights From the IVQ 2024 Results
NEWS
On February 10, 2025 Prospect Capital (PSEC) released its IVQ 2024 results and followed up the next day with its conference call.
ANALYSIS
We thought we’d discuss a number of items we noticed when reviewing the earnings press release and the conference call transcript.
Re-positioning of the portfolio
Last quarter, PSEC’s management announced its intention to drastically change its investment strategy. This was to involve gradually jettisoning its investments in CLO equity and real estate, as well as its control positions in a number of companies. Instead, PSEC wants to focus on what most BDCs are already involved in: lending and investing in “middle market” companies, typically those owned by private equity groups.
Rome was not built in a day and BDCs cannot be re-positioned in a quarter unless – like Barings BDC (BBDC) you sell the entire portfolio to a third party buyer and start again.
We got the impression from what we were told that PSEC has made (very modest) progress towards its goals.
Name Dropping
Once again, the BDC mentioned in its earnings report the investment in Taos Footwear, the subject of a press release just a few days ago, which we discussed in the News Feed.
Several other new portfolio companies were also mentioned and – in some cases – some additional information about them was forthcoming.
Here’s an example:
Discovery Point Retreat is a rapidly growing detox and rehabilitation provider in North Texas. Recent EBITDA had increased by approximately 37% from underwritten EBITDA only a few months ago. We’ve worked with Druid’s management team to enter into a new service agreement with the goal of purchasing such facility in the future as an expansion into California. Druid has also moved its Dallas outpatient program to a new location that more than doubles capacity and has begun construction at one of its inpatient facilities to expand capacity. Discovery management believes these initiatives each will lead to continued growth.PSEC CC
Small Step
Note, though, that the value of actual middle market originations booked in IVQ 2024 came to only $95mn. That’s not very much in a total portfolio in excess of $7bn.
At this sort of pace, PSEC will need many, many years to turn itself into a mostly standard issue middle market lender.
(Also, for reasons we don’t understand PSEC in the IVQ 2024 and in the beginning of 2025 has continued to add real estate investments to the portfolio).
2. Middle Market Or Upper Middle Market?
Everybody has a different definition of what is a lower middle market (LMM); middle market (MM) or upper middle market (UMM).
Very broadly, we consider a borrower with EBITDA under $25mn to operate in the LMM, $25mn-$75mn in the MM and above $75mn in the UMM.
These distinctions are important because each of these market segments tend to have different pricing and terms.
Which?
PSEC tends to use the term “middle market” but its earnings press release indicates the weighted average EBITDA of its borrowers is over $100mn.
Tellingly, the “Weighted Average Net Leverage Ratio” of these companies is 6.1x, which sounds like the levels we have learned to expect from the UMM.
This suggests that PSEC is marketing itself to very large borrowers at a time when the spreads on first lien loans to those sort of businesses are under great pressure, getting booked at SOFR + 5.00%-5.50%.
Of course, UMM loans are also often booked at much higher spreads but these facilities typically involve more problematic or – as the lenders like to say – more “complex credits”.
Selection Of Recent New Loans
Recently PSEC booked a first lien loan to Wellful at SOFR +5.00% and a second lien for 0.25% more.
(By the way, KNS Holdco – the parent of Wellful – was rated D by S&P at the end of 2024 and has only recently been upgraded to CCC+. The ratings group repeatedly warns in its latest analysis: “KNS’ capital structure is unsustainable over the long term”. To be fair, though, S&P rates as a B the first lien Term Loan to Wellful which PSEC is invested in. The second lien loan – which the BDC also holds – is rated CCC+).12/24/2024 Data from S&P
A first lien first out loan to the recently restructured Research Now/Dynata was priced at 3 month SOFR + 5.0%.
Playpower – another company we’re familiar with – was booked in August at SOFR + 5.25%.
By contrast, Druid City – another recent borrower – is paying SOFR + 7.50%. That’s a juicier yield but suggests more risk.
These examples suggest PSEC is operating in the UMM and booking a range of creditworthiness.
3. Spread Compression
Yet Another Example
Readers must be tired by now about hearing about “spread compression” but this factor is critical to every BDC’s profitability and PSEC is no exception.
This quarter, the yield on the overall portfolio has dropped to 9.1%.
This is important because PSEC – and most everyone else – is caught in a spread sandwich, with investment yields coming down while borrowing costs are remaining high, or increasing.
Basic Math
Let’s look at PSEC’s cost of borrowing secured:
We have been told that PSEC pays its secured Revolver lenders SOFR + 2.05%, or about 6.40% in total at the moment.
When you add the 2.00% management fee PSEC charges, the total cost of investing using secured debt comes to 8.40%.
The net spread is 0.7% (9.1 – 8.4), dropping to something below 0.5% after direct costs and PSEC’s 20% Incentive Fee is applied.
Unsecured Debt And Preferred To The Rescue
Thankfully, there is an inverted yield curve right now and PSEC is able to borrow unsecured at a much lower rate than on its Revolver.
Nonetheless, management must be keen to boost its investment yield to help widen its spread.
Low
One obvious step is to unload more of its real estate portfolio whose aggregate yield is only 6.9%.
In its press release, PSEC repeated – as they do every quarter – the large number of real estate properties sold historically:
In our real estate property portfolio at National Property REIT Corp. (“NPRC”), since the inception of this strategy in 2012 and through December 31, 2024, we have exited 51 property investments (including two exits in the December 2024 quarter) that have earned an unlevered investment-level gross cash IRR of 24.3% and cash on cash multiple of 2.5 times.PSEC Press Release
However, when we checked the 10-Q, we calculated that the $1bn+ total cost of the RE portfolio has dropped by only ($38mn) in the last 3 months.
At that pace, re-positioning out of real estate will take many years to complete.
Also Low Yielding
Moreover, from a GAAP standpoint, PSEC’s “structured notes” are not making much of a contribution, yielding only 3.9%.
These CLO equity investments are on the cutting block but only $57mn at cost were disposed of in the IVQ 2024.
At that pace, the CLOs won’t be gone till mid-2027.
Until many more “middle market” loans are booked and the real estate and CLO assets are removed, PSEC’s portfolio yield is going to be under pressure.
Keeping The Worst Till Last
Even more challenging for PSEC will be moving away from its coterie of “control” investments where PSEC essentially pays itself – and has not been shy to charge very high rates.
For example, the First Tower Finance debt – which accounts for 13% of PSEC’s net assets – costs the borrower 15.0%. One Interdent loan is priced at 19.1%.
“Control” investments at cost – outside of the REIT – account for a third of the portfolio, so any shift away from this segment will cause PSEC earnings and portfolio yield to drop precipitously.
Value Of Real Estate
As noted by PSEC in its press release, the unrealized gain in its real estate company is $522 million.
That’s a huge number, and easily the main reason why the BDC’s overall portfolio at FMV exceeds its cost by 1.5%.
We are not challenging the valuation because we have no alternative data to offer, and we assume PSEC has reams of supporting appraisals.
However – if the value of the real estate IS over-stated and gets adjusted down the road, the possible impact on PSEC’s NAVPS could be significant.
Using our envelope back, we calculate that writing the RE to cost would bring PSEC’s NAVPS down by ($1.23) a share, or (16%) of its net worth.
PSEC – in its press releases – likes to mention the unlevered IRR and cash on cash return on properties sold, but we’d rather know whether a realized gain is being achieved in the traditional GAAP format.
VIEWS
Idiosyncratic
PSEC has always been an unusual BDC. Management prides itself on taking a different approach than most of its peers – and has done so in a number of areas.
As a result, we were a little surprised when last quarter the change of strategy was announced and PSEC announced its plans to become like everyone else and pursue “middle market” lending and investing.
We speculated at the time – and our view remains unchanged – that this might be a way to prepare the BDC for an eventual sale to another asset manager.
Moreover, “necessity is the mother of invention” and management may have recognized that its venture into real estate, CLOs and being both owner and lender to a few large companies was a dead end.
Slow Going
The IVQ 2024 data – when unpacked as we’ve done here – suggests the re-positioning is going slowly.
The good news for PSEC shareholders in the short run is that the BDC’s recurring earnings did not drop much in the quarter.
NIIPS came in at $0.20 per share, only ($0.01) per share down from the prior quarter, and way better than the $0.14 per share predicted by the only analyst still following the BDC. (We’re quoting from Yahoo Finance).
Unsure
We really can’t tell how long PSEC is going to take making this radical change in its portfolio and cannot yet ascertain what the ultimate earnings and return on equity might be.
Nor are we sure that some of the valuations supporting the BDC’s investments and NAVPS might not melt away as more and more assets are sold.
We can analyze all we like but there are too many unknowns here to draw a picture of what PSEC might look like one, two or three years out.
The BDC Reporter will just have to keep updating our readers from quarter to quarter till this re-positioning comes into focus.