The past few weeks we have heard a lot of concerns about business development companies and the risks they face in 2015. These funds make loans to companies to middle-market companies for expansion and buyouts of competitors.
In the past two years they have seen an expanded opportunity as banks have pulled back from this type of lending as part of their effort to re-risk their balance sheet and investors have benefited from high dividend yields that are often in the double digits.
Now we are hearing a lot of talk about potential dividend cuts and the risk of higher interest rates next year.
The only ones not worried about the outlook for BDCs are the officers and directors of these funds. They have been buying shares of their funds at a rapid rate. They are either completely unaware of the dangers or they are a lot more confident that Wall Street about their ability to thrive next year.
Much of the negative chatter was started when Prospect Capital Corporation (PSEC) chose to reduce its monthly dividend from 11 cents per share to 8.3 cents per share. The market didn’t like the move and PSEC stock has dropped more than 15% in the past month.
The dividend cut was not a result of any negative portfolio activity but was more a result of repositioning the portfolio toward lower risk. As CEO John Barry put it:
“As our updated credit statistics show, we have elected in the past year to take on less risk and focus on higher earnings quality by increasing our percentage of first lien loans and accepting lower interest rates in this yield compressed environment.”
Company executives seem to think this lower-risk, lower-dividend approach will work well in 2015 — Barry purchased 247,000 shares of PSEC stock in two transactions this month. CFO Brian Oswald bought 226,000 shares in the last two weeks, and COO Grier Eliasek has purchased 75,000 shares since Dec. 1.
PSEC stock has gotten very cheap since the dividend cut was announced and Prospect Capital now trades for 86% of the last reported net asset value. Even after the dividend cut, the shares are yielding more than 12% and there is a strong possibility of special dividends, Barry said in a statement:
“We believe there may be upside to our new reduced dividend level, a dividend level we believe we can sustain over the next year and longer even with no dividends or fees from portfolio companies. We also believe we should wait for upside events to occur before committing to any increase in our dividend. … To the extent our taxable earnings continue to exceed NII as well as our regular dividends, we may need to declare additional special dividends to meet our requirement as a tax-efficient regulated investment company to distribute 90% of our taxable income to shareholders.”
The selling in PSEC stock appears to be overdone. There is no credit problem in the portfolio as the nonperforming loan is just .03% of total loans.
It is preparing to spin off three parts of the portfolio, leaving investors with four very distinct portfolios — collateralized loan obligations, structured credit, online lending and real estate. Much of the loan portfolio is adjustable rate so they are ready for higher interest rates.
Although investors have dumped PSEC stock in the wake of the dividend cut, the prospect for shares of Prospect Capital seems to be pretty good. Insiders think so, as they been loading up on the shares on weakness recently.
As of this writing, Tim Melvin is long PSEC.
