Editor’s Note: In our ongoing effort to improve Hedgeye research, we’d like your feedback on the Stock Report below. If a write-up of each stock on Investing Ideas is valuable to you, let us know. Feedback about the stock report’s length or the content is also welcome.
This report was generated using published research from our REITs Sector Head Rob Simone.
A REIT Hiding in a BDC “Pyramid”
Prospect Capital (PSEC) is a Business Development Company (BDC) that has several unique characteristics that make it one of the most compelling short ideas in our coverage right now. While not itself a REIT, our REIT team has analyzed the company owing to the fact that a private REIT, NP REIT (“NPRC”), is PSEC’s largest investment and comprises an outsized share of the portfolio and net asset value (NAV). We believe that PSEC’s equity is worth close to zero, but just happens to still have a price and a ~$2 billion equity market cap.
We believe the arrangement with NPRC is not economic, not sustainable, a “negative sum” game and requires PSEC to rely on external capital. They are factually doing so by issuing a very risky series of non-traded preferred stock to retail investors. In our view this is both wrong and will ultimately crush the common equity and result in dividend cuts.
This is a relatively new short call, added to Investing Ideas on December 8, and the stock price has fallen 7% since.
National Property REIT (“NPRC”)
NPRC comprises ~20% of PSEC’s BDC portfolio and ~40% of reported NAV, for a company that is supposed to spread risk across many small and medium size businesses. We believe NPRC is to PSEC what Steward is to MPW – a case of “mutually assured destruction” that will ultimately result in the near destruction of PSEC’s common equity value.
NPRC is Over-Levered + Not Generating Cash
Using NPRC’s financial statements, which are filed and reported by PSEC, it is clear that NPRC is not generating sufficient cash flow to fund itself. We believe this is likely due to the high degree of leverage and related interest cost at NPRC. Mortgages were obtained on the assets at ~80% loan-to-cost (LTC), and NPRC has additional debt due to PSEC.
Support From PSEC
PSEC is filling the cash flow deficit by lending money via term loans to NPRC. NPRC has not acquired a new property in 7 quarters, over which time PSEC sends over ~$250 million of term loan draws to NPRC.
PSEC Books the Interest Income on Term Loans as “Earnings”
PSEC earns interest income from NPRC, funded in part from working capital support from PSEC itself. We estimate that non-cash payment-in-kind (PIK) interest + interest income from NPRC represents ~75% of PSEC’s net investment income, i.e. this portion of PSEC’s earnings is not “real” or “economic.” The relationship is circular and a “negative sum game.”
PSEC’S NON-TRADED PREFERRED
The capital for PSEC to support NPRC needs to come from somewhere. PSEC’s answer since late-2020 has been to issue a series of non-traded preferred stock to retail investors via broker dealer channels. They have raised ~$1.5 billion of this preferred to fund NPRC, as well as dividend payments plus fees to PSEC’s affiliated external manager, PCM.
We believe these securities carry substantially more risk and leverage than PSEC markets, including the risk that the preferred can be force-converted to common at the option of the Board. While issuing this private non-traded preferred at par, PSEC has tendered for a series of public preferred at a discount.
We believe:
- Investors and RIAs should avoid this security, and
- A failure by PSEC to continue selling it will cut off PSEC’s funding and break down the “house of cards.”
Conclusion: Short PSEC
Appendix: Key Financial Terms
- Business Development Company (BDC): A Business Development Company (BDC) is a publicly traded company in the U.S. that invests in small and mid-sized businesses, offering them capital for growth. BDCs are regulated by the SEC and must invest at least 70% of their assets in private or public U.S. companies with market values of less than $250 million. They distribute at least 90% of their taxable income to shareholders as dividends.
- Net Asset Value (NAV): The net value of an investment fund's assets less its liabilities, divided by the number of shares outstanding. Most commonly used in the context of a mutual fund or an exchange-traded fund (ETF), NAV is the price at which the shares of the funds registered with the U.S. Securities and Exchange Commission (SEC) are traded.
- Payment-in-Kind (PIK): The use of a good or service as payment instead of cash. Payment-in-kind also refers to a financial instrument that pays interest or dividends to investors of bonds, notes, or preferred stock with additional securities or equity instead of cash.
- Loan-to-Cost (LTC): A financial metric that measures the percentage of a project's total cost that is financed by a loan.
