Wednesday, April 13, 2011

Prospect Capital (PSEC) - What a Difference a Year Makes

(Author's note: I originally started this post with the goal of highlighting some of the changes PSEC has made to their company over the past year. In light of their recent equity raise - a private offering of 9 million shares at a market price destroying $11.40 a share maybe the management of PSEC still is learning. To be fair, the offering does add to Book Value. Although their continued practice of announcing "good news" and trying to sneak in some "bad news" does not sit well. The only way you can find the current pricing of the offering is to go into the SEC filing that I linked above.)

It has been just over a year since Prospect Capital's attempted acquisition of Allied was denied by Allied's management in one of the most eviscerating letters you will see written by a public company . Let us review some of the highlights:
  • As a result of this review, Allied’s Board of Directors has unanimously concluded that this revised offer does not constitute, and is not reasonably likely to result in, a “Superior Proposal” as defined under our merger agreement with Ares Capital Corporation (“Ares” or “ARCC”). Allied’s Board of Directors has unanimously reaffirmed its recommendation that Allied shareholders vote for the transaction with Ares announced on October 26, 2009.
Allied added the bold for emphasis.

  • During our discussions, Prospect made claims to have access to a significant amount of third party capital. While we were intrigued by these references, Prospect was unwilling to disclose any details, including the identity of the mysterious capital source, nor was Prospect willing to provide any information regarding the financial outline of a potential transaction.
Allied called Prospect out for their lack of transparency in the transaction and refuted the idea that Prospect had been an actual suitor. It is interesting to note that ARCC never increased their takeover offer in response to PSEC.
  • We believe Prospect’s unsolicited offer does NOT provide Allied shareholders “Superior Value” as compared to the Ares transaction.
PSEC had made an offer that on its surface was at a premium to ARCC's offer. At the time of PSEC's revised offer to acquire ARCC, the transaction would have resulted in a 20% premium over ARCC's offer. Allied noted that after this offer was made, PSEC's stock dropped more than 5% and eroded the premium. In front, most of the market knew that taking over Allied would have been too much for PSEC to handle. After the offer was withdrawn, PSEC's stock price rebounded.

  • We believe a merger with Allied would put Prospect’s dividend at risk, resulting in a near term dividend cut, which would reduce Prospect’s stock price and imply a lower value for Allied’s shareholders
For PSEC to complete this transaction, they would have to more than double the current share count. Given PSEC's eroding Net Interest Income, the only way to maintain the dividend would be to pay out of Capital Gains realized upon completion of the merger and asset write-ups. At the time of the offer, PSEC was already underfunding their dividend by 50%. In retrospect, the management team at Allied was correct and PSEC cut the dividend in May from 41 cents a quarter to 10 cents per month (25% reduction per quarter + they "skipped" the Q2 dividend by only paying 10 cents, although the change to monthly does provide a salve). Further underscoring the lack of transparency, the management team at PSEC hid this dividend cut in another news release discussing Q4 results. The market did not take this news well and the stock dropped another 10% in the aftermath.
  • We believe Prospect lacks the managerial expertise to run the combined company.
This one is calling a spade a spade. Allied acknowledged PSEC was still in the "Junior Varsity" of the BDC league and would have a difficult time handling the merger. While this may or may not be true, PSEC did have a much smaller investment/support staff and they would have tripled their investment portfolio.
  • There is no assurance that any agreement with Prospect could be reached or closed
Allied knows PSEC has not done its research and any delays would only hurt shareholder value. Also, Allied had already agreed to pay ARCC a $30mm "break-up" fee if the merger did not come to pass (it dropped to $15mm if the ALD shareholders had voted against ARCC).

  • We believe Prospect has limited liquidity to operate the combined business
Ares (ARCC) had more relationships and available credit lines to draw than PSEC. Since that time PSEC and ARCC have both reorganized their debt structure. For example, PSEC's revolver is now is one-month LIBOR plus 325 basis points, subject to a minimum LIBOR floor of 100 basis points as opposed to 400 basis points with a floor of 200 basis points.

  • We believe the Prospect management platform is inferior to the Ares management platform, providing weaker long term growth opportunities for Allied’s shareholders. Allied’s Board has no confidence in Prospect’s ability to manage the assets in Allied’s portfolio.
Again, this is basically saying PSEC was not ready for the big-time yet.

  • We believe the acquisition of Patriot Capital further weakens Prospect’s platform, making Prospect a less attractive merger partner.  
There is always the risk of taking on too much at once. Allied and Ares were already down the line with regards to integrating their firms with ARCC purchasing the unitranche fund in November 2009. While these steps may call into question if Allied would have considered another offer from any BDC, PSEC was still working on integrating the PCAP assets at this time.

  • Prospect has a track record of highly dilutive equity capital raises which we do not believe provides responsible growth to shareholders.
Most BDCs at the time were issuing shares below NAV that were dilutive to shareholders. This was the nature of the beast in 2009-2010 before capital markets reopened. The below chart (care of PSEC's Prospectus) shows the dilutive issues.

  • We believe, by combining with Prospect, Allied shareholders would be inheriting a much riskier portfolio.
Prospect had recently acquired the PCAP portfolio, which if you had the chance to review before the acquisition was head scratching at best (one investment made prior to PCAP going under was in a hot-tub maker even though the recession had already taken hold). Prospect's management has turned the portfolio around and as of December 31, 2010, about 2.3% of the net assets were on non-accrual (as opposed to 6.8% as of the Allied letter).

Allied management closed the letter with a unanimous "No" against PSEC and the ARCC merger went through as of April 1st 2010.

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