As noted in a December 24, 2015 article in The New York Times (“Obscure Corner of Wall St. Draws Skepticism from Investors”), one obscure sector of the stock market – Business Development Companies (“BDCs”) – has been the subject of increasing controversy over some of its results and fees.
BDCs are firms that were created by Congress in 1980 to encourage investment in small businesses whose growth may generate jobs. They sell stock to the public and then use some of the proceeds to make loans to emerging businesses for a variety of needs. The category has grown tenfold over the last decade, to $64 billion in assets. That is partly because business development companies offer higher yields in exchange for the high-risk nature of their assets, and partly because they cater to a market that big banks have retreated from since the financial crisis.
One of the most criticized business development companies, however, is Prospect Capital Corporation (NASDAQ: PSEC). With $6.6 billion in assets as of September 30, 2015, Prospect is a large player in the category. But in the last year and a half, its stock price and net-asset value per share have been steadily sinking. Even before the recent junk-bond market upheaval, Prospect has traded at a discount to net-asset-value of more than 30 percent this year, well below the average of less than 20 percent for such firms.
Some analysts have accused Prospect of charging what they say are conspicuously high fees, even as investor returns have faltered. And others have taken issue with the compensation paid its chief executive, John F. Barry III — more than $100 million annually in recent years, according to estimates by former employees and an outside analyst.
Prospect invests in high-yield, high-risk assets like stocks, loans and bonds of companies through private equity buyouts, finance companies, debt pools like collateralized loan obligations, real estate investment trusts, aircraft leasing and even online loans – a significant portion of which are leveraged. Prospect’s fees, however, like those of many business development companies, are similar to those of private equity funds. Its external manager charges a 2 percent annual management fee on all assets plus an incentive fee of 20 percent of certain income gains — and administrative expenses — at the high end of the sector. For its fiscal year that ended in June, the Barry-owned manager received fees and expenses totaling $240 million, or about 3.5 percent of its total assets, according to the company’s annual report.
Some analysts say Prospect has often paid out dividends above its earnings, and sold stock below its book value, both of which can hurt investors. Both moves have helped Prospect raise its assets tenfold since 2008, also increasing fees. With its shares down 34 percent in the last 17 months, Prospect has curtailed new stock sales. As a result, growth of its assets slowed to 5 percent in its latest fiscal year from an annual rate of 58 percent over the previous five years.
One reason for Prospect’s big discount to net-asset value, now 28 percent, is that some investors are skeptical of the value Prospect reports for some assets – commonly referred to as “Level 3” assets – which means that, rather than being priced based on actual trade prices, these investments are valued by management based on their own estimates and valuation models.
The combination of leverage, questionable Level 3 valuations and excessive fees are, more often than not, an indication of potential significant concern – especially in a rising interest rate environment.
If you are an individual or institutional investor who has any concerns about your investment in Prospect Capital Corporation or any other Business Development Company (“BDC”), please contact us for a no-cost and no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an individual securities arbitration claim with the Financial Industry Regulatory Authority (FINRA).