Dividend Coverage:
This next chart, taken from Prospect’s recent quarterly earnings presentation, shows that Prospect’s dividend coverage ratio is narrow (keeping in mind, Prospect is a BDC and regulated investment company, and thereby pays little to no corporate income tax, as long as it pays out at least 90% of its income as dividends).
And in the most recently announced quarter, Prospect paid out more in dividends per share ($0.25) than it earned in NII ($0.22). This is a payout ratio greater than one, which is generally unhealthy and unsustainable over the long-term. And in our view, given our current point in the market cycle, Prospect’s dividend may become increasingly challenging to sustain, particularly if its new originations offer lower yields and if its big ROE continues to decline as it has been in recent years as shown in our earlier chart.
External Management Conflicts of Interest:
Prospect Capital is an externally managed BDC and this creates conflicts of interest between management (Prospect Capital Management (PCM)), and shareholders. For example, according to Prospect’s most recent 10-K, PCM’s liability is limited under the Investment Advisory Agreement, which may lead PCM to take on higher risk investments. Further, PCM is paid an incentive fee based on NII which can incentivize them to take on higher risk and less profitable investments simply to grow overall NII which is not necessarily in shareholder’s best interest. Additionally, the incentive fee can incentivize management to issue new shares to fund growth in NII (and growth in their incentive fees), but this can be dilutive to existing shareholders considering the shares trade at a discount to the company’s net asset value. For some perspective, the following chart shows new equity issuance for internally managed (blue dots) versus externally managed (green dots) BDCs.
The noticeable observation is that internally-managed BDCs have a track record of issuing new shares at a premium to their net asset values (suggesting investors expect a strong return on assets) whereas externally-managed BDCs have a track record of issuing new shares at a discount to their net asset values (suggesting they’re more interested in growing assets under management, total NII and their own incentive fees, instead of focusing on per share profitability for shareholders). Therefore, if you’re going to invest in a BDC, we generally prefer internally managed BDCs (and incidentally, the one remaining BDC we own in our Blue Harbinger High Income Equity portfolio is internally managed).
Three healthier big-dividends than Prospect:
While the high dividend yield and monthly payments offered by Prospect Capital are tempting, we believe there are healthier investment opportunities, that offer outsized dividend payments, as well as better price appreciation potential, and we’ve highlighted three of them below.
1. EPR Properties (NYSE:EPR)
EPR Properties (NYSE:EPR) is a big-dividend retail REIT that we first added to our watch list last summer as an alternative to the then overpriced, lower-yielding, Realty Income, as shown in the following chart.
At the time, we described EPR as an attractive REIT “priced for growth,” but noted that it can be “difficult to hit the buy button on a security that has just rallied like EPR,” and we suggested that income-seeking investors “add this one [EPR] to your watch list, and consider buying on the next pullback.” As the following chart shows, that pullback has arrived, and we believe EPR Properties (NYSE:EPR) is an attractive alternative to Prospect Capital because it offers a large dividend payment (5.6% yield) and considerably more price appreciation potential than Prospect, in our view.
