2023-06-15 06:15:00 ET
Summary
- FS KKR and Prospect Capital both trade at heavy discounts to NAV driving higher dividend yields of 11.4% to 15.5%.
- We compare the credit quality of their portfolios to help explain why these companies trade at much lower multiples.
- We also discuss one of Prospect Capital's primary investments that recently filed for bankruptcy, likely driving upcoming NAV decline and lower earnings.
- Please see the chart at the end of this article comparing the potential impact on NAV per share for each BDC, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery.
Quick Introduction To business Development Companies
Business development companies ("BDCs") invest shareholder capital in privately-owned, small- and medium-sized U.S. companies generating income from secured loans and capital gains from equity positions, much like venture capital or private equity funds. Anyone can invest in BDCs as they are public companies traded on major stock exchanges. Also, many BDCs have investment grade ("IG") bonds/notes for lower-risk investors building a balanced 60/40 portfolio (composed of 60% to 70% stocks/equities and 30% to 40% bonds or other fixed-income offerings).
This article compares portfolio credit quality for FS KKR Capital ( FSK ) and Prospect Capital ( PSEC ) which currently have among the lowest price-to-NAV multiples, as shown below, likely for the reasons discussed below.
Please see the chart at the end of this article comparing the potential impact on net asset value ("NAV") per share for each BDC, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery.
Comparing Portfolio Credit Quality
Author's Note: The following information was provided to subscribers of Sustainable Dividends along with a constantly updated full risk profile and rankings for FSK and PSEC .
FS KKR Capital
During calendar Q1 2023, FKS's non-accrual investments increased from 2.4% to 2.7% of the total portfolio at fair value (5.5% at cost) mostly due to adding its "watch list" investments in Wittur Holding and Monitronics .
Its net asset value ("NAV") increased by $0.04 or 0.2% (from $24.89 to $24.93) due to over-earning the dividend and accretive share repurchases partially offset by net realized/unrealized losses of $30 million. There was another $58 million or $0.21 per share of realized losses including the exits of its non-accrual investments. There has been a total of $710 million or $2.53 per share of net realized losses over the last eight years and its NAV per share has declined by 32% over the last five years:
There are many factors to take into account when assessing dividend coverage for BDCs including portfolio credit quality, realized losses, fee structures including "total return hurdles" taking into account capital losses, changes to portfolio yields, borrowing rates, the amount of non-recurring and non-cash income including payment-in-kind (“PIK”). Most BDCs have around 2% to 8% PIK income and I pay close attention once it is over ~5% of interest income. Higher amounts of PIK is typically a sign that portfolio companies are not able to pay interest expense in cash and could imply potential credit issues over the coming quarters. The amount of PIK interest income remains around 12% of the total interest income.
Even after taking into account the recent exits/repayments from Advanced Lighting Technologies , Angelica (LP portion), and Sungard Availability Services (second lien portion), the amount of "watch list" investments remains 16.5% of the portfolio fair value (21.3% at cost) and around 36% of NAV, which is more than most BDCs . Some of my concerns include many of its asset-based finance (“ABF”), capital goods, and software investments as well as real estate and aircraft leasing exposure (similar to previous declines from Global Jet ).
Avida Holding, Reliant Rehab Hospital, One Call Care Management, Accuride Corp, Prime ST , and Pure Fishing , could potentially be added to non-accrual status over the coming quarters.
Prospect Capital
During calendar Q1 2023, PSEC's NAV per share declined by $0.46 or 4.6% (from $9.94 to $9.48) mostly due to marking down its second-lien and equity positions in PGX Holdings responsible for $0.31 per share, equity position in First Tower Finance responsible for around $0.07 per share, and its equity position in National Property REIT responsible for around $0.05 per share.
The second-lien position of its watch list investment in Rising Tide Holdings was added to non-accruals status, which still has a first-lien position on accrual marked at full value. United Sporting Companies, Engine Group, and USES Corp remain on non-accrual status
Earlier this month, PGX Holdings filed for bankruptcy, citing a recent loss in a court case brought by the CFPB over its billing for credit repair services seeking $3 billion in damages from PGX, after a Utah federal judge ruled in March that the company violated a federal law that prohibits up-front billing for credit repair services. PGX entered bankruptcy with about $4 million cash on hand, nowhere near enough to pay the CFPB's proposed judgment.
It should be noted that PSEC only marked down the second-lien position in PGX, which was recently restructured to a 100% capitalized PIK/deferred interest and both positions were on accrual status as of March 31, 2023. This investment accounted for over $250 million or 3.3% of the portfolio at cost and around 5% of PSEC's NAV, even after the recent markdowns.
National Property REIT , PGX Holdings , InterDent, Valley Electric , and First Tower Finance still account for almost $3.0 billion, or almost 40% of the total portfolio, and 79% of NAV per share, as shown below. This is a very high concentration risk, especially if management is using aggressive valuation measures. The following table shows the total amount of unrealized gains from these five investments is over $1 billion, which has added $2.50 to its NAV per share. If these investments were marked back down to cost, the current NAV per share would decline from $9.48 to $6.98 . During an economic recession, this is a very real possibility for some of these investments and investors should be prepared for a certain amount of markdowns.
The following is from PSEC’s recent 10-Q:
During the nine months ended March 31, 2023, the valuation methodology for PGX Holdings, Inc. (“PGX”) for the First and Second Lien Term Loans changed from the yield method to the CVM method, due to a restructuring of the equity ownership during the current period. Leading into March 2023, PGX was undergoing a litigation process commenced by the Consumer Financial Protection Bureau regarding the legality of PGX’s billing practices when using telemarketing to acquire new business. Due to recent rulings issued by the courts in these legal proceedings, PGX determined it needed to move away from a telemarketing model to an online model to attract new customers. As a result of this material change to PGX’s business model (which will take time to develop) and other impacts from the court rulings, our investment in PGX First and Second Lien Term Loans decreased to $184,656 as of March 31, 2023, a discount of $65,969. The fair value at June 30, 2022 equaled its amortized cost.”
PGX Holdings Inc was approved for a $12 million bankruptcy loan, which it will use to auction its assets after the U.S. Consumer Financial Protection Bureau successfully challenged its billing practices. U.S. Bankruptcy Judge Craig Goldblatt in Wilmington, Delaware approved the loan, allowing PGX to borrow additional funds from its primary lenders, Blue Torch Finance LLC and Prospect Capital. Blue Torch controls PGX's $243.5 million senior loan and could end up owning the company if no other buyer emerges. PGX filed for bankruptcy on Monday, citing a recent loss in a court case brought by the CFPB over its billing for credit repair services. The consumer watchdog agency is seeking $3 billion in damages from PGX after a Utah federal judge ruled in March that the company violated a federal law that prohibits up-front billing for credit repair services. PGX attorney Spencer Winters said at a Tuesday court hearing that PGX entered bankruptcy with about $4 million cash on hand, nowhere near enough to pay the CFPB's proposed judgment. The litigation also forced PGX to dramatically scale back its operations, making it more difficult for the company to make payments on more than $400 million in loans that are unrelated to the lawsuit, Winters said.
PGX ceased all telemarketing and monthly billing for about 80% of its customers, based on the Utah court's ruling, it cannot send bills to customers who have enrolled over the phone without proving that their credit score has improved. The company recently laid off 900 employees, leaving just 300 employees on its payroll. It has alleged that the company took $3.1 billion in improper up-front fees from four million consumers, including a $15 sign-up fee and $15 in monthly service fees. PGX has said that 71% of its customers improved their credit scores as a result of its services. The case is PGX Holdings Inc, U.S. Bankruptcy Court for the District of Delaware, No. 23-10718.
Credit repair business Progrexion was hit with a proposed class action just one day into the company’s Chapter 11 bankruptcy case, facing allegations it abruptly terminated about 900 employees without advance notice in early April. Progrexion and related bankrupt entities held by PGX Holdings Inc. violated the Worker Adjustment and Retraining Notification Act when it conducted mass layoffs of telemarketers at its central operating facilities in Utah, according to a suit filed Monday in the US Bankruptcy Court for the District of Delaware.
As of March 31, 2023, almost 19% of the portfolio was equity positions in a small group of investments, and more than 9% invested in the equity class of the collateralized loan obligation (“CLO”), which are considered non-qualified investments due to the amount of off-balance sheet leverage (typically 10 times) used to achieve returns. Together these account for almost 30% of the portfolio and banks will not allow these assets to be used as collateral for credit lines, which is why PSEC needs to use subordinated notes and preferred stock for most of its borrowings.
PSEC management has historically amended loan terms to include higher amounts of PIK, which has increased from 14% to 24% of total interest income for calendar Q1 2023:
BDC Valuations and Comparing Watch Lists
Author's Note: The following information was provided to subscribers of Sustainable Dividends along with updated target prices and suggested limit orders (for making purchases) for FSK and PSEC .
There are very specific reasons for the prices that BDCs trade driving higher and lower yields mostly related to portfolio credit quality and dividend coverage potential (not necessarily historical coverage). BDCs with higher-quality credit platforms and management typically have higher-quality portfolios and investors pay higher prices. This drives higher multiples to NAV and lower yields.
The following chart shows the potential impact on NAV per share for each BDC, assuming that 100% of watch list investments (including non-accruals) defaulted with 0% recovery. This is the worst-case scenario for this group of investments. It's important to note that the chart only takes into account watch list investments and any changes to other positions will also have an impact (positive or negative). For example, BDCs with larger amounts of equity positions, most of which are not included in the watch lists, will likely have more NAV volatility (higher or lower). Subscribers that believe the economy is headed for a "hard landing" with a deep, broad, and/or extended recession should focus on the BDCs closer to the top left corner . The largest NAV declines over the last four quarters was mostly BDCs with larger amounts of watch list investments.
As mentioned earlier, FSK's watch list investments account for 21.3% of the portfolio at cost and around 36% of NAV, which is much more than most BDCs , as shown below. However, PSEC's is much more than that and does not fit on the chart so please expect large NAV declines over the coming quarters which is likely why the stock trades 34% below its previous NAV per share.
I only invest in higher quality BDCs so I do not own FSK or PSEC but if I had to choose one it would be FSK that I have slowly started to upgrade and waiting for credit quality to improve before starting a position. As for PSEC, I believe the "wheels at starting to come off" and the previous NAV stability was supported by aggressive asset valuations. Adding PGX to non-accrual status will drive lower earnings of around $0.06 to $0.07 per share annually compared to the current monthly dividend of $0.06 per share ($0.72 per share annually).
For further details see:
Better High-Yield Buy: FS KKR Or Prospect Capital?