Prospect Capital: The Bulls Have It Wrong

Business development companies are all about trust. You have to trust that management will make capital allocation decisions that favor the interests of shareholders, not managers. And you have to trust that a management team will mark its book appropriately, not inflate the value of its assets at every turn.

In recent months, I've been very critical of how Prospect Capital has marked its assets, particularly assets that are underperforming. In cases where Prospect Capital owns a security that another entity also owns, I've found that Prospect Capital routinely marks its investment at higher prices. It often lags writing down assets by several quarters at a time, slowly walking down their value rather than marking to the then-current market value.

I'd like to go through a few examples of interesting events in Prospect Capital's financial filings.

1. What's a loan to Empire Today worth?Prospect Capital owns senior secured notes to Empire Today that it currently values at 83% of principal. This loan has been written down three times in a row, the first of which occurred in the calendar fourth quarter of 2014.

Conveniently, several asset managers report that their funds also own this same loan. In tracking how Prospect marks this loan relative to other asset managers, it becomes clear that Prospect Capital was once several quarters behind in marking it down and has smoothed out its declining value over time.

Here's a table of how Prospect Capital valued this loan compared to three other asset managers.

Source: SEC filings.

Notice that Prospect Capital's writedowns are smooth, lagging the valuations the three other investors ascribe to the Empire Today loan. After writing this loan down three quarters in a row, Prospect Capital is still carrying it at higher prices than other funds managed (and valued) by other fund companies.

2. What's a second-lien loan to Targus worth?Prospect Capital owns a second-lien term loan to Targus, which was marked up modestly this quarter. Another BDC, Gladstone Capital, also owns this loan and marks it to the "indicative broker bid" in most quarters (i.e., the market price).

Notably, Prospect Capital lagged in marking down this loan, too. The only quarter in which their valuations aligned was the sole quarter in which Gladstone did not mark the loan to the broker bid, according to footnotes in its financial filings.

At one point, Prospect Capital marked the loan at a 17-point premium to the indicative broker bid. The largest markdowns came in the first quarters of 2014 and 2015, when Targus was downgraded by Moody's.

3. What's Edmentum worth?In the fourth calendar quarter of 2014, education company Edmentum quickly soured. Several BDCs that owned the loan carried it at par until the fourth quarter, when it was marked down considerably. While fair values varied, it's notable that Prospect Capital registered the smallest unrealized loss on its investment, carrying it at substantially higher prices than peers.

Source: SEC filings.

4. No, really, what's Edmentum worth?Edmentum completed restructuring in the second quarter of 2015. The restructuring resulted in realized capital losses for all BDCs involved in the deal. Some of the balance owed on the loans was converted to equity.

What's the equity worth per share?

If you ask Prospect Capital, each share of Edmentum is worth $17.73, significantly higher than others that hold the exact same equity investment.

Source: SEC filings.

It's quite possible the other investors hadn't yet done the work to mark their investment in Edmentum prior to filing second-quarter results. More likely, in my view, is that Prospect Capital used the opportunity to defer capital losses that it should have taken in the most recent quarter into future quarters, consistent with its behavior regarding Empire Today, Targus, and Edmentum prior to its restructuring.

5. What's Harbortouch worth?Prospect Capital reported a significant increase in the valuation of one of its controlled companies, Harbortouch, in its most recent quarter. In fact, it more than doubled the equity value of the company from the first to the second quarter.

Prospect Capital management deferred responsibility for the write-up to its third-party valuation service, saying, "we don't do valuations around here." An analyst remarked that he was "surprised at how aggressive the actual mark up in the valuation was." He's not the only one. Given an implied 2% increase in revenue year over year, this write-up appears to be driven by expanding the multiple used to value the company, not its performance.

6. How profitable is Nationwide Holdings?In the most recent quarter, Prospect Capital invested $1.876 million into the equity of controlled company Nationwide Holdings. In the same quarter, it took a $1.981 million dividend from Nationwide.

In other words, capital went in as an investment, and a similar amount came right back out as dividend income. Odd. That added about half of one cent to net investment income per share in the fourth quarter.When a BDC just barely covers its dividend with net investment income for the first time in several quarters, transactions like these deserve additional scrutiny.

7. What do these actions say about other interesting marks?In the most recent quarter, Prospect Capital:

Wrote down its investment in Pacific World by roughly $13.4 million despite an additional draw on its revolving line of credit of $4 million, for a total writedown of $16.9 million. This investment is worth 5% of Prospect Capital's net asset value. Given past history of small writedowns preceding several quarters of additional writedowns, what can investors expect from this portfolio company?
Wrote up its investment in United States Environmental Services by about $6.8 million, despite the fact it is still paying an additional 2% in "default interest," presumably due to a covenant violation. Notably, Prospect Capital wrote down the value of several of its controlled oil services-related investments in the most recent quarter. These companies include CP Energy, Arctic Energy Services, and Freedom Marine Solutions.

These are your marksAs much as Prospect Capital's management likes to defer responsibility for marking its portfolio companies to third-party valuation consultants, these are, by law, the marks of Prospect Capital's Board of Directors.

As an Ernst & Young note explains:

It goes on to say:

There is nothing novel about using a third-party valuation service, nor does using one give the Board of Directors a free pass to push their responsibility onto someone else. Consider that carefully in the coming months, as two of five board members will be up for reelection this year, one of whom is on Prospect Capital's audit committee.

Writing down losing assets slowly results in permanently inflated net asset value, more fees to the asset manager, and better earnings in the present at the cost of lower earnings in the future. It also calls into question the offsetting increases in its portfolio's value. If a company will mark an asset higher than its peers do, one can only imagine what it can do with its controlled companies -- companies where there are no other owners to compare the marks.

Given the number of occasions in which Prospect Capital marked its assets at higher prices than peers, I think any rational investor would conclude that perhaps Prospect Capital's book, if valued by another company, would be worth significantly less than currently reported. Prospect Capital, and its bullish supporters, have a lot of explaining to do.

The article Prospect Capital: The Bulls Have It Wrong originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.