Business Development Corporations, or BDCs, are a favorite among high-yield investors, thanks to their pass-through nature.
Specifically this means that, in order to maintain their preferential tax status, BDCs are required to pay out 90% of taxable net income as dividends. This naturally creates one of Wall Street’s highest-yielding industries, but also means that dividend lovers need to be very careful about with whom they entrust their hard-earned money.
That’s because, with almost no ability to retain earnings, BDCs can only grow by raising external debt and equity capital. Or, to put it another way, new money is always flowing into BDCs, which means poor management teams can hide the fact that they might be lighting shareholder money on fire.
So let’s take a look at the two ends of the BDC quality spectrum: Main Street Capital (NYSE:MAIN), the gold standard of the industry, and Prospect Capital (NASDAQ:PSEC), which has proven itself notorious for destroying shareholder value. Learn what really matters in this industry, and why chasing yield, and counterintuitively, the wrong kind of value, could end up costing you a fortune.
Prospect Capital: A Horror Show Of A BDC
(Source: Earnings Release)
There is simply no way to sugarcoat it: Prospect Capital is a capital allocation train wreck.
Management claims that this quarter’s (and fiscal year’s) horrific results, including both top and bottom lines falling off a cliff, is part of a well thought-out, disciplined and conservative strategy to “preserve capital, reduce risk, and avoid chasing yield.” That means cutting new originations in half and reducing leverage from a debt/equity ratio of 75.6% last quarter to just 70.5% now.
Of course, what will immediately catch investors’ attention is the 28% dividend cut, the BDC’s second in the last two years (in February 2015, PSEC cut its dividend by 25%).
The real question that investors need to be asking management is what the heck took so long for them to realize the rising dangers inherent with a late business/credit cycle and the compressing yields and declining risk-adjusted total returns that go with it?
(Source: Prospect Capital Earnings Release)
Of course, given the high-risk nature of BDCs (they are essentially subprime lenders), I would applaud this move, even the dividend cut, if Prospect were actually telling the truth.
However, rather than getting religion on not “chasing yield” through dangerous loans, Prospect Capital’s portfolio hasn’t actually gotten significantly safer. For example, while its total loan book has shrunk slightly from a year ago and its exposure to energy is lower, note that the percentage of its portfolio that is structured credit and equity, i.e., the two riskiest forms of BDC investing, has actually increased from 28% a year ago to 31.7% today. Meanwhile secured first-lien debt, the safest kind of BDC loans and what one might assume Prospect’s talk about a renewed focus on safety and quality lending means, is actually down by 1.7% over the past year.
Meanwhile, nonperforming loans are way up, and the company’s net asset value, or NAV, per share (the best objective way to determine whether or not management is creating shareholder value or destroying it) is down another 3.1%.
Of course, given Prospect’s shady history of refusing to mark down deteriorating loans until the last possible moment, it is likely that the NAV/share continues to be artificially inflated.
The same is true regarding non-accrual loans, which the BDC has in the past hidden by either refinancing loans that are about to default with fresh ones (thus keeping non-accrual loans loans artificially low), or outright converting failed loans to equity in distressed companies that are essentially worth zero.
However, here is the biggest reason to doubt management’s justifications.
Take a look at fiscal 2017’s originations, which represented a record high for the company. In fact, net originations, meaning accounting for paid off loans, were much better than in 2016.
However, despite a massive increase in overall deals this year, including loans that are not safer (and thus should be boosting portfolio yield), Prospect’s overall net interest income fell off a cliff and portfolio yield continues to decline, as does its NAV/share, NII/share and now the dividend.
The bottom line is that management is not doing what it’s claiming to with regard to a turnaround at Prospect Capital. This means the BDC’s fundamentals are likely to continue to deteriorate in the future. Especially when we finally enter a recession and Prospect’s default rates inevitably soar.
Main Street Capital: The Best-Run BDC In The World
In direct contrast to Prospect Capital’s calamitous quarter, Main Street, the Berkshire Hathaway (NYSE:BRK.B) of BDCs, managed to not just grow but accelerate its growth rate, while maintaining precisely the kind of high underwriting standards that Prospect Capital claims to be pursuing.
In fact, while Prospect’s net originations in the past quarter were -$129 million, Main Street somehow managed to originate $107 million in net deals to grow its portfolio by 5.8%.
(Sources: PSEC, MAIN Earnings Releases)
More importantly, given that we are in the late stages of the current business/credit cycle, which has caused Prospect’s management to bemoan that “We’re seeing spread compression everywhere we look,” the fact that Main Street’s portfolio yield has actually held up over the past five quarters indicates that Prospect’s woes are not some secular industry trend but rather a function of management’s inability to grow profitably in a higher-risk environment.
Prospect’s Cost Of Capital
(Sources: Morningstar, Earnings Release, F.A.S.T. Graphs, GuruFocus)
That’s not surprising given that Prospect’s weighted average cost of capital, or WACC, is so much higher than Main Street’s.
Main Street’s Cost Of Capital
(Sources: Morningstar, Earnings Release, F.A.S.T. Graphs, GuruFocus)
This is Main Street’s greatest competitive advantage over its rival BDCs – specifically that it can obtain growth capital at such low rates, that it can achieve superior profitability while taking on much less risk, and thus maintain high lending standards, as well as enjoy a larger, untapped lending market.
For example, middle market loans, which represent Main Street’s second-largest loan segment, are generally made to larger and more financially sound companies – the kind that are more likely to survive the next recession.
In Q2 2017, Main Street’s average middle market loan was for 8.8%. Those are relatively low risk, first-lien loans that most larger BDCs can’t afford to make because the yield is simply too low.
Prospect Capital, with a WACC of 9.1%, would literally be losing money if it were to try to compete with Main Street, so it doesn’t. Which is precisely where Main Street gets its edge – from a lack of competing capital pouring into its high-quality/low-risk part of the market and compressing spreads.
(Source: Main Street Investor Presentation)
Another major component of Main Street’s industry low cost of capital is the fact that it’s one of the few internally managed BDCs, meaning that management works directly for shareholders rather than operate as an outsourced third party, being paid fees as a percentage of assets.
The differences in this pay and cost structure can be enormous, with Main Street capable of generating 61% greater shareholder value over 20 years than an average externally managed BDC (and Prospect is certainly below average).
(Source: Morningstar, GuruFocus)
You can also see the differences in the these BDCs’ respective cost structures in their vastly different profitability.
However, given that Prospect Capital continues to be a highly profitable company, why are investors suffering yet another dividend cut? This is in contrast to Main Street shareholders, who have seen nothing but steady dividend growth over the years (including during the Great Recession).
Main Street Dividends Over Time
Corporate Culture Makes All The Difference
A major risk with any external managed BDC is that there can be an inherent conflict of interest between what’s best for management and shareholders. That’s because external management companies, such as Prospect Capital Management, which is led by CEO John Barry III, are paid both a base management fee and an incentive fee.
Specifically, Prospect Capital’s Management’s agreement with PSEC is for a base fee of 2% of gross assets, plus 20% of any growth in NII (above a low 7% hurdle rate) and 20% of capital gains. In other words, the standard hedge fund “2% and 20%” arrangement. And just like hedge funds, management can sometimes care more about boosting its own pay than enriching shareholders. After all, if your pay is tied not to share specific metrics, such as NII/share, NAV/share, or most importantly dividend/share, then management can be incentivized to grow assets even if it ends up destroying shareholder value, as occurs every time shares are sold below NAV.
And indeed that has been the case, with Prospect Capital tapping equity markets (to sell new shares) far more than Main Street Capital.
More damning is that during much of that time, Prospect Capital shares have been trading at a discount to NAV. In fact, over the past five years, when Prospect was printing shares like Venezuela does bolivars, the median price to NAV was just 0.903.
In contrast, Main Street Capital was selling new shares at a 57.4% premium to NAV, which was immediately accretive to existing investors. In essence, Main Street was printing free money to invest wisely.
Prospect management. meanwhile, was willing to sell $1 in assets for $0.90, thus diluting existing investors and resulting in massive shareholder wealth destruction, just so they could grow the BDC’s assets, their own fees and their salary. And what a glorious salary it is, at least for CEO John Barry.
According to some former Prospect Capital Management employees, Barry was paid over $100 million a year in 2013 and 2014, years in which Prospect Capital’s total management fees were $151.0 million and $198.3 million, respectively. That’s on total revenue of $576.3 million and $713.2 million, respectively, indicating that in those years, (at least according to insiders), he took home about 57% of all management fees and about 15.5% of all revenue.
Even more shocking? Over the past year, Prospect Capital’s management was paid $199.4 million in total fees out of a total of $701.0 million in revenue. In other words, 28.1 cents of every dollar in the door is going straight into management’s pocket, and if we assume the same management pay breakdown as in 2013 and 2014 (57% to Barry), about $113.7 million (16.2% of revenue) of that is going directly to Barry himself.
Now, before anyone accuses me of some kind of Occupy Wall Street anti-capitalist bias, let me assure you that even if Barry is in fact bringing home about $115 million a year in pay, I don’t begrudge him that windfall one bit. After all, in a free market system, execs can ask for as much compensation as they want and companies end up paying what they think CEOs are worth. And as long as a BDC’s business is thriving, its dividend is generous, secure and growing, and the share price is rising nicely, resulting in market beating total returns, I wouldn’t care if he was bringing home $1 billion a year.
But of course Prospect is not thriving, but rather flailing, as today’s 28% dividend cut undoubtedly proves, yet management continues to get paid lavishly. In fact, as a % of revenue, this past year’s management fee of 28.1% is higher than it was back in 2013 (26.2%), which is something shareholders should be outraged over and would probably demand be stopped if Prospect were internally managed. But since Prospect shareholders have no say whatsoever, they can only vote their dispproval via selling their shares (which is what I highly recommend you do).
This brings me to the reason why I make such a big deal of how much management, and Barry in particular, is paid.
Prospect Capital’s Insider Ownership Swindle
One of the things you hear a lot from Prospect bulls is that management is always buying tons of shares on the open market and never sells. This creates high insider ownership and aligns management interests with retail investors.
And as you can see above, this is absolutely true. PSEC management buys shares frequently, usually (though not in 2017) in large quantities, and never sells.
And understandably, Barry, who’s probably taking home about 15-16% of total revenue himself, is doing the majority of that buying. In fact, 93.75% of the 6.24% of PSEC shares owned by insiders are held by possibly one of the highest-paid CEOs in the world. For example, while Barry hasn’t bought any shares in 2017, in 2016 he did buy $49.7 million worth, bringing his total holdings in PSEC to about $149 million (based on the current $7 share price).
Of course, in 2016, PSEC management was paid $219.3 million, and Barry, assuming that earlier 57% share, took home $125 million, meaning that the $50 million in share purchases represented 40% of his his salary (and also that he was the highest-paid CEO in the world in 2016).
In other words, I would postulate that Prospect’s high insider ownership and frequent executive buying (which is actually a requirement the company has) are nothing but a smoke screen. Specifically, by putting a fraction of this extremely generous (to say the least) pay into shares of the company (which all pay a generous, if steadily declining, dividend), Prospect can then attempt to quell investor fears and help to keep the share price as high as possible for as long as possible. After all, management is eating its own cooking.
And how does Main Street Capital, with its industry-leading, internally managed executive team, compare to the “Wolf Of Wall Street” crowd at Prospect Capital?
Main Street Is The Berkshire Hathaway Of BDCs
Thanks to being internally managed, we can actually tell exactly how much Main Street’s c-Suite is bringing home.
In 2016, Main Street’s execs took home $10.9 million paid out of $192 million in total revenue, or 5.7%. Chairman and CEO Vincent Foster, meanwhile, took home $3.5 million last year, or 32% of all executive pay, and 1.8% of revenue (1% in salary, the rest in stock).
And while Prospect’s management fees must also cover overhead as well as non-executive pay (making more exact comparisons impossible), we can estimate that Main Street’s far superior CEO is being paid proportionally about 60 times less than John Barry ($114 million versus $1.9 million).
But what about insider ownership? Well, the good news is that Main Street’s executive team actually believes in their company (and ours) a lot more that PSEC’s management does theirs.
In fact, just like at PSEC, Main Street execs are required to own a certain multiple of their pay in stock. And just like at PSEC, MAIN execs are consistent buyers, with only one insider sale seen in the past 3.5 years.
Even more impressive? While wildly overpaid PSEC management owns 6.24% of the BDC’s shares, arguably underpaid MAIN management owns 6.18% – essentially the same.
More importantly, the actual insider ownership at Main Street is far broader, and thus, I would argue a greater sign of management confidence in the BDC. After all, John Barry owns 94% of all insider shares, meaning that relatively speaking he is the only exec at PSEC with much confidence in the stock (or more likely, he is doing his part to support investor confidence, the share price, and thus keep the good times rolling).
In contrast, Vincent Foster owns 44% of insider shares, with the rest of the c-Suite very well represented. In fact, I would argue that Foster’s insider ownership and open market buying is actually greater than Barry’s on a proportional basis. For example, in 2016, while Foster’s total compensation was $3.5 million, only $1.9 million was in cash, with the rest in restricted stock options.
In comparison, Main Street’s CEO bought $949,000 in shares on the open market. That means Main Street’s CEO spent 50% of his cash salary in 2016 buying shares of his company. Not only is that 20% greater than Barry’s (40% of salary on shares), but Foster’s salary is 60 times smaller than Barry’s. In other words, Main Street’s CEO, and indeed almost all of its executives, show an almost Warren Buffett-like dedication to eating their own cooking.
But wait, Main Street’s supremacy over Prospect hardly ends at management cost structures and pay packages.
Dividend Profile Speaks Volumes
(Sources: GuruFocus, Earnings Releases, F.A.S.T. Graphs, FactSet Research, Multpl.com, Moneychimp.com)
At the end of the day, dividend investing is about two things, and two things only: income and total return.
That means we need our investments to have not just a high yield but a safe dividend, and one that’s likely to grow over time.
(Source: BDC Buzz)
As you can see, Prospect’s NII/share has been steadily declining over time, thus necessitating its 28% dividend cut.
In contrast, Main Street Capital has proven that it can grow its distributable NII/share consistently over time, including during recessions, and the worst oil crash in over 50 years (which caused many BDCs immense trouble).
The result is staggering and undeniable: Main Street has been the best dividend growth stock in its industry, while Prospect has been an utter failure.
Keep in mind that this chart shows Main Street’s regular dividend. The spikes represent the now biennial special dividend, which is funded out of Main Street’s capital gains on its equity investments (and not DNII).
Now, in fairness to Prospect Capital, the dividend collapse was not as bad as it looks in this chart. That’s because PSEC didn’t move to a monthly payout until June of 2010, and so, its peak dividend of $0.41/quarter in Q1 2010 represents a $0.137/share monthly payout. That means today’s forward monthly dividend of $0.06 is only a 54% decline in seven years, representing an annual dividend growth rate of -11.1% over that time.
However, I want you to consider that for a second, in the context of being a dividend growth investor.
PSEC has, since the end of the financial crisis, during a time when interest rates were the lowest in human history, and during a very steady and long-lasting economic expansion, managed to achieve a negative double-digit dividend growth rate.
In other words, during what should have been a golden age or a once in lifetime celestial alignment of profits for Prospect shareholders, their dividend – the only reason for owning any BDC – has been declining rapidly.
Now, as the business and credit cycle matures, the percentage of PSEC’s loans in nonaccrual status are rising steadily, its net investment spread (Portfolio yield – WACC) is shrinking (with no end in sight), and its dividend is being hacked to pieces, while management tries to assuage invest fears by claiming that all is well and going to plan.
Meanwhile, while management appears to be desperately trying to de-risk the portfolio (and failing), the steady and very heavy insider buying that has been so comforting to PSEC shareholders has suddenly stopped.
That tells me that Prospect is likely in deeper trouble than many investors realize, potentially even caught in a death spiral, ironically enough because of its very low valuation.
Valuation: You Get What You Pay For
At the end of the day, any individual stock investment you make should beat the market, because otherwise you’re wasting your time and should just buy a low-cost index ETF and patiently wait to get rich.
And as you can see, over the past decade, while the S&P 500 hasn’t done all that great courtesy of the 55% plunge it took during the financial crisis, you still would have done a heck of lot better owning an index fund compared to the crappy 3.9% annual total return, (3.3% adjusted for inflation) that PSEC gave you.
On the other hand, thanks to Main Street’s far superior business model (as well as a management team who doesn’t pay itself at the expense of investors), the company has generated 20.7% annual total returns (17.5% adjusted for inflation).
In other words, while Prospect’s CEO may be paid 32 more than Main Street’s (60 times more on a salary basis), Main Street has, over the long term, delivered 5.5 times better real total returns (potentially indicating that Barry deserves a salary cut of 330 times to $354,000 a year).
But what does this have to do with valuation? Everything.
A Better Way To Value BDCs
Unlike standard dividend stocks which fund growth internally with retained earnings and cash flow, BDCs need a constant source of cheap capital in order to not just grow their asset base but also to simply replace maturing loans. That means constantly selling new shares, and that leads to the potential for destructive liquidity traps and the death spirals (endless decline in NAV, NII/share, dividends and share price) they can produce produce.
Specifically, I mean that if a BDC can’t sell new shares for a premium to NAV, which essentially represents the market’s valuation of management (after all, they only exist to allocate capital better than we investors can), it will have a hard time not only growing its dividend but even maintaining it.
What this means is that the standard approach to valuing BDCs, using P/NAV, is dead wrong. That’s highly counterintuitive, so let me explain.
In theory, if a BDC owns $1/share in interest-bearing loans, then value investors should never pay more than $1 per share for the BDC, and in fact, should try to buy it at a discount.
But here’s why that’s crazy. It’s no different than arguing that Yahoo (YHOO) was a great investment back when its enterprise value (market cap – net cash) was less than its market cap. In reality, it meant that Wall Street was saying Yahoo’s core business was a perennial value destroyer – only a fool would buy that.
Well, today Prospect Capital trades at a P/NAV of 0.723, while Main Street trades at 1.74. So at first glance, many investors think that Prospect offers the chance to buy $1 in assets for $0.723, while Main Street is demanding $1.74 for $1 in assets.
Crazy, right? Obviously, Prospect is a great value investment, because you’re literally buying a dollar for 72 cents. It’s free money! While only a fool would buy Main Street, where you’re paying $1.74 for a dollar.
Indeed, the correct answer is obvious, but it’s actually the reverse.
Set aside the fact that Prospect’s NAV is likely overstated by management’s refusal to write down loans to market value until the last possible moment, here’s what a P/NAV of 0.723 really means. The market is saying that Prospect’s management is so horrible, or at least so hell bent on paying itself first, that if you give them $1 in assets you’ll get $0.72 back.
Indeed, we’ve seen that precisely 28.1% of every dollar in revenue PSEC generated in the past year actually ended up in management’s pocket. And as we’ve seen with the company’s poor dividend coverage, its atrocious dividend growth record and abysmal total return versus both the broader market and MAIN, management at Prospect can only be looking out for itself.
After all, with results this disastrous, there can be only two possibilities. First, management is utterly incompentent, to a mind-boggling, Greek tragedy-like extent. Or, second, Prospect Capital isn’t floundering at all, but rather executing beautifully, exactly as intended from the start. As a cash cow for management, so that it can (and potentially will) end up paying its CEO and founder over $1 billion for running a terribly performing (from investors’ perspective) hedge fund.
And given that I can’t, for the life of me, imagine a world so crazy that a complete buffoon can wind up making over $100 million a year and eventually becoming a billionaire, I must conclude that John Barry and the rest of the management at Prospect Capital are highly skilled investors, but only working towards maximizing their next pay day.
However, that means Prospect Capital is a fatally flawed investment, one whose NAV is destined to continue declining over time, and thus neutralizing any apparent discount you may think you’re buying at the moment.
Which is why, no matter how low Prospect Capital may fall, I will never purchase it and can’t recommend anyone else does either. Theoretically, you could try speculating in PSEC by market timing based on P/NAV versus its historical range, as some have done successfully in the past year or so.
However, from my perspective, investing is a long-term strategy in which you buy high-quality, income-producing assets run by competent, honest and trustworthy management, whose share price rises over time (courtesy of dividend growth).
Main Street has that in spades, and it is literally the world’s best BDC. It’s blessed with a management team that is emulating Buffett and Berkshire’s long-term investment strategy, as well as earning an impeccable reputation for high-integrity business practices. This is why, I have no problem buying Main Street Capital today or recommending it to others (as long as your time horizon is long enough, meaning 7+ years). Because at the end of the day, a 1.74 NAV premium is really telling you that investors have incredible confidence that each $1 in assets handed to Main Street’s management will become $1.74 in future assets discounted to the present.
In addition, each share sold by MAIN at such a premium results in literally printing free money, which management invests with a skill that almost no other BDC can match. In other words, Main Street’s premium (as is the case with the industry-specific premium of any pass-through stock, such as REITs, MLPs, yieldCos, mREITs and LPs) is similar to Berkshire’s insurance float. A free source of growth that, in the hands of world-class management, ensures that winners keep on winning.
Now, this approach taken to an extreme can also be crazy. After all, if MAIN Street’s high share price simply allows the company to grow faster, then wouldn’t this logic dictate that you should keep buying shares at any price? P/NAV of 2, 3, 10! The higher the valuation the more accretive to existing shareholders each new sold share is, and so, Main Street should theoretically be a “buy at any price” stock.
Of course that’s not true, because remember, studies show that over the long term, total returns equal yield + dividend growth. This puts a natural cap on how much you should be willing to pay to earn likely market-beating total returns. After all, if MAIN were trading at a P/NAV of 10 ($224), then the yield of 1.2% would result in a very bond-like 4.2-5.2% total return profile.
This makes intuitive sense, because while theoretically MAIN could raise so much free money at $224 as to grow its assets, and thus DNII, and dividend fast enough to achieve a market-beating return, in real life the world doesn’t allow such perfect scalability.
For example, if MAIN shares did jump to $224, then management could theoretically raise $2.24 billion by selling 10 million new shares (diluting investors by 17.5%). However, there simply doesn’t exist that many high-quality lending/equity opportunities, so there would be no commensurate growth boom from such a large premium to NAV. It’s thus unlikely that investors would ever allow such a ludicrous bubble price to appear.
But what if Main Street were to rise to a price of $43.5, a total yield (including special dividends) of 6.5% (P/NAV of 1.94) and a point where long-term total returns are still 10%. Does that mean MAIN is still worth buying then?
In my view, the answer is actually “Yes,” but only you have no other superior alternatives, such as quality dividend growth stocks with dividend total return profiles of 11%, 12% or more.
Bottom Line: The Choice Is Clear – A Hedge Fund Swindle Or The Berkshire Of BDCs
There is no other way to say it. Prospect Capital is no less than a hedge fund run purely for the benefit of management, and it has proven itself a legendary destroyer of shareholder value. Ultimately successful BDC investing is all about finding a talented, experienced and, above all else, trustworthy management team to invest with.
Prospect’s management team has spent the last decade more than proving that shareholders should never trust it. Thus, no matter how low the share price drops or what kind of discount to NAV the stock may appear to offer, this is one BDC that deserves to be on your “never buy list.”
In contrast, Main Street Capital’s internal management structure, combined with high insider ownership and an unbeatable track record of long-term shareholder wealth creation (across a full business cycle), proves without a doubt that it’s hands down the best BDC in the world.
More importantly, the company’s growth engine continues to fire on all cylinders, indicating that investors can expect continued payout growth that should continue generating market-beating total returns for many years to come, and thus still make it a good long-term buy today.
Disclosure: I am/we are long MAIN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
One High Yield Stock To Buy And Hold Forever, And One To Avoid At All Costs – Seeking Alpha