Description

Prospect Energy (PSEC) is one of a few new Business Development Corporations (BDCs). Negative market reaction to aspects of its first transaction and tax loss selling, have provided a discounted entry to the stock, which has bright long term investment qualities.

First, a quick review of the BDC business model: BDCs are a special class of regulated investment company (RIC) required to invest mainly in smaller private businesses. In return for serving as a capital source for these markets, and with the stipulation they must distribute nearly all their income to their shareholders, BDCs are not taxed at the corporate level. They are restricted to a maximum debt to equity ratio of 1:1. This combination of limited leverage, and distribution of income mandates that BDCs regularly tap the equity markets for capital to grow their business. Generally, because of the high cash yield from the shares, the market routinely prices BDCs at a premium to net asset value (NAV). Thus the subsequent equity offerings are generally accretive to NAV per share, and are a relatively low cost source of capital to fund growth. BDC investments are typically mezzanine loans which may or may not have equity components. The key to success is very good investment selection, and proper pricing of these transactions. An investor in these stocks must have a high level of confidence in the management because of the opacity of the private portfolio companies.

Management
PSEC is a BDC format for Prospect, which has been operating in the energy sector since 1988. The CEO, John F Barry, has been with the company since 1990. Prospect has invested over $1.5B. While the BDC format is new, evaluating and managing these types of investments is not. Prospect has an extensive network of contacts in the energy sector that will support ongoing attractive deal flow.
Investment Strategy
PSEC will specialize in investments in the energy sector. The target energy investments fall in four broad areas: ‘upstream businesses’ find, develop and extract energy resources; ‘midstream businesses’ gather, process, refine, store and transmit energy resources and their byproducts; ‘downstream businesses’ include the power and electricity segment as well as businesses that process, refine, market or distribute hydrocarbons or other energy resources to end-user customers. Also included are companies that sell products and services to, or acquire products and services from, the direct energy value chain.

The attraction to the energy sector is based on the knowledge there are many potential transactions in this $700B in revenue sector. Associated assets are around $1T. PSEC will profit on the ability to focus on a sector that by its nature tends to have steady recurring cash flows, and is asset-intensive, thus providing a greater level of tangible collateral for securing loans. In addition, at present the multiples to cash flow in these investments are lower than in other more typical BDC portfolio candidates. This better pricing in a sector PSEC knows well favors long term success.

Gas Solutions

PSEC’s first investment was the $30.344 buyout of Gas Solutions (GS) in late September. In the 10Q and a subsequent 8K/A, the details of the transaction have become clearer. GS was generating annualized cash flow after cap ex of $8.3MM. This is a 3.66x multiple. Immediately following the purchase, additional business was secured, and in the Q, GS is reporting an expected 10MM annual operating cash flow, less up to 1MM in maintenance cap ex. At 9MM pre tax FCF, PSEC’s purchase multiple was 3.37x. Interest coverage is 2.56x. The business has ready expansion capacity at its two gas processing plants.

GS Transaction Perception Problems

Two issues quickly arose that generated fear and a falling PSEC price in the marketplace.

First, was a concern that the $30MM deal was larger than the 25% maximum of assets allowable under BDC regs. (PSEC has assets around $97MM) PSEC indicated it will restructure the GS debt it now wholly holds, to reduce its portion of the capital structure in GS, or alternatively it can increase its own capital with some debt, to get the appropriate ratio. I expect the former is the likely solution, and PSEC indicated in the Q it had received 2 term sheets to accomplish this. But either way this ‘problem’ is readily solved.

The second headline to rock PSEC was the filing of a lawsuit over the GS transaction, seeking up to 100MM in damages. PSEC had originally been in the role of a debt provider to aid a third party, MNW, in the buyout of GS. As the deadlines approached for the closing, MNW was allegedly having difficulty completing its portion of the transaction. After further negotiation, MNW stepped aside, signed releases, accepted fees in connection with the deal and allowed PSEC to step in. PSEC was quite thoughtful before choosing to describe the suit as “frivolous and without merit” in its press release on the matter.

While I have not seen the court filings I’ve had some correspondence with those who have, and it is hard to discern any real damage. The original deal had PSEC lending and receiving 40% equity...that was to be repurchased in 5 years at 5xEBITDA. MNW would get, at most, 400K/year out of cash flows (depending on operational performance) as a management fee, plus the 60% equity. In the back and forth available in e-mails filed with the court, it seems to come down to a difference in vesting schedule for the 60% equity for MNW, and whether the management fee would be in or out. Finally PSEC said it would only do the deal if MNW gets a finders fee, and is not the management. In the end the fee was $2.5MM.

PSEC was willing to do a lender based deal vs. a buyout. Even if the court required MNW to be back in, PSEC would still have a desirable debt investment. Given the large fee paid to MNW, it’s hard to see the near term monetary damages. Given MNW’s alleged difficulties in meeting their requirements, and the time pressure to meet closing deadlines, one can conclude they actually did all right in the circumstances. MNW took the money, after refusing a deal that still included them and was very close to terms they put forth in a counter offer. It hardly seems like they were under duress.

The Future

Of the 12 investment candidates listed in the final prospectus, 4 are still in process to become actual transactions according to the Q. PSEC stated they expected to have the original IPO capital invested by the end of June, 2005. After that, in the normal BDC business cycle, one can expect leveraging, followed by subsequent sales of equity to fund further growth. Modeling the business in this manner produces per share net operating income and dividends of $.55-.60 through June 2005 (note .10 paid end of December); $1.10-1.20 in FY06, and $1.30-1.45 in FY07. Following the typical BDC stock pricing pattern of premium to NAV, one can justify a price of around $18 by the first half of ‘06 and $22 a year later. The final price versus the midrange for the dividend is a 6.25% yield price. That’s a lower yield than ACAS, but comparable to GLAD

Thus from an initial investment of $12.20, in 18 months one can project a total return of about $7.35 or 60%. In 2.5 years the total return is about $12.65 for around a 100% total return.

One major difference in PSEC vs. ACAS is in the form of compensation of management. ACAS uses options which allow for greater cash flow over a smaller stock base in the near term. But those options are structured with dividend related declining strike prices that effectively provide desired management compensation rates at the price of future dilution. PSEC, like some other recent BDCs has elected to use current cash compensation to achieve management compensation goals. Combining a 2% gross asset fee, with an effective 20% of pre fee net operating income (if a 7-8.1785% return on net asset hurdle is met) and a capital gains incentive fee, gets the PSEC management the same kind of compensation ACAS claims it is achieving through options. PSEC’s system is more transparent at the price of being front loaded. The stock prices I project assume market acceptance of less cash in the PSEC dividend now, in return for non dilution of future dividends by management options. It allows a lower premium to NAV than ACAS has enjoyed through much of its history, in return for the lower dividend yield.

The primary risk going forward is execution risk. Management has stumbled in creating the circumstances that permitted the negative perceptions. Neither is likely to be meaningful in the long term in my opinion, but the incidents provide a cautionary note. The choice of the energy sector just on the deal pricing exhibited in the GS transaction mitigates this somewhat.

The margin of safety is the unusual stock price below NAV of $13.67. BDCs typically price above NAV, and even fellow IPO BDCs AINV and ARCC are already priced above NAV. Once the market eases its worries over the two items discussed above, I expect PSEC to price in the same pattern.

Catalyst

1) End of tax loss selling pressure next week.
2) Adjustment on the relative size of the GS transaction to conform to BDC regs.
3) Clarity on the merit of the lawsuit.
4) Successful unfolding of the typical new BDC dividend growth pattern.