PSEC Q3 2023 Update: Slight Improvements But Credit Quality Still A Concern
Please use the following link to access all the recently updated reports, including side-by-side comparison reports and individual company updates:
PSEC Quick Quarterly Update (September 30, 2023)
Pricing: No change. I will reassess after updating the projections. Please see the BDC Sector Weekly Update from earlier this week for target prices for all BDCs.
Earnings: Reported just below its best-case projections due to higher-than-expected structuring fee income from National Property REIT and lower Other G & A expenses.
Payment-in-Kind (“PIK”) Income: Decreased from 17.3% to 11.4% of interest income (from 15.4% to 9.8% of total income), which is much better than FSK and MRCC.
Realized Losses: $207 million or $0.51 per share mostly due to restructuring PGX Holdings, as mentioned later.
Dividends: Maintained its regular monthly dividend of $0.06 per share through January 2024 and expects to declare subsequent distributions in February 2024.
Credit Quality: Non-accrual investments decreased from 1.1% to 0.2% of the total portfolio at fair value mostly due to restructuring PGX Holdings partially offset by adding its small second-lien loan to Strategic Materials ($7 million loan). Also, its second-lien loan to Rising Tide ($12 million PIK loan) was added back to accrual status.
NAV Per Share: Increased by $0.01 or 0.1% (from $9.24 to $9.25) due to overearning the dividends by $0.07 per share mostly offset by issuing shares through its DRIP and conversion of its preferred stock diluting NAV by $0.04 per share plus net realized/unrealized losses of $0.02 per share.
This information will be discussed in the updated PSEC Deep Dive Projection report.
As shown below, there were almost 4.6 million additional shares issued during Q3 2023 mostly through conversion of its preferred stock plus the dividend reinvestment plan (“DRIP”) at a 5% discount to the market price. The weighted average price of the newly issued shares was around $6.00 or a 35% discount to NAV per share resulting in a dilution of around $0.04 per share.
On September 28, 2023, PGX underwent a corporate restructuring with the new borrower being Credit.com Holdings. As part of the transaction, the first-lien term loan was restructured into new debt, resulting in a realized loss of $1.5 million, and the second-lien term loan was written off resulting in a realized loss of $180.0 million. In connection with a Chapter 11 process, PGX sold the majority of its assets to Credit.com Holdings, and PSEC was issued equity at Credit.com, through its Class B non-voting equity investment in PGX Topco.
National Property REIT, First Tower Finance, InterDent, Valley Electric, and Credit.com/PGX, still accounted for $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 uses aggressive valuation measures.
The following table shows the total amount of unrealized gains remains 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 $9.25 to $6.75. During an economic recession, this is a possibility for some of these investments, and investors should be prepared for a certain amount of markdowns.
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 sources of income including payment-in-kind (“PIK”). Higher amounts of PIK for lower-quality BDCs 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.
Most BDCs have around 2% to 8% PIK income and I pay close attention once it is over ~5% of total interest income. The amount of PIK interest income for PSEC recently decreased from 17.3% to 11.4% of interest income (from 15.4% to 9.8% of total income), which is much better than FSK and MRCC.
As of September 30, 2023, over 18% of the portfolio was equity positions in a small group of investments, and around 8% 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 27% 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.