As is often the case, the larger the dividend yield the more risky the payout. I talk about this quite a bit in the video: ‘Dividends, Dividends, Dividends.’ Please have a look. All else equal, we tend to prefer cash-flow-based operating companies such as Microsoft (MSFT) rather than opaque, risky structures such as business development companies (BDC’s), where traditional fundamental analysis is less-informative.
Sure enough, a dividend cut at Prospect Capital (PSEC) came in a warm holiday package today. The business development company announced that it will reduce cash dividends to shareholders to $0.08333 on a monthly basis with the following record and payment dates:
8.333 cents per share for February 2015 (record date of February 27, 2015 and payment date of March 19, 2015);
8.333 cents per share for March 2015 (record date of March 31, 2015 and payment date of April 23, 2015); and
8.333 cents per share for April 2015 (record date of April 30, 2015 and payment date of May 21, 2015).
Prospect’s expected dividends will mark a ~25% reduction from its prior dividend of $0.1106.
You may ask: Why are we writing about a firm that just announced it has cut its dividend? Well, for one, the lure of a monthly cash dividend payout has attracted many a financial advisor to scoop up shares to satisfy clients’ monthly income needs. Second, even after the dividend cut, Prospect will have a forward yield of 11.7%, luring new individual investors to the table. To us, we see it as our responsibility to inform financial advisors and individual investors of the significant risks related to BDCs–not only related to the sustainability of the dividend, but also related to the material risk of capital erosion, which has been the case at Prospect for some time. The business models of BDC’s are not as transparent as we would prefer.
Prospect said that the reason for the dividend cut centered on electing “in the past year to take on less risk and focus on higher earnings quality by increasing (the) percentage of first lien loans and accepting lower interest rates in this yield compressed environment.” We give credit to management for not chasing higher yields on investments with abnormal risk profiles, but that doesn’t mean its income investors are happy. Instead, it speaks to the challenging environment of a BDC, and the entity’s inextricable ties to the interest rate markets.
Management threw in a teaser in the press release for dividend growth investors, nonetheless:
“We believe there may be upside to our new reduced dividend level, a dividend level we believe we can sustain over the next year and longer even with no dividends or fees from portfolio companies. We also believe we should wait for upside events to occur before committing to any increase in our dividend. If we earn one penny per quarter or more in dividends or fees from portfolio companies, we expect to earn $1.00 per share or more in NII over the next twelve months (25 cents per share or more on average each quarter). As a result, we believe 8.333 cents per share per month is a sustainable payment from NII over the next 12 months. To the extent our taxable earnings continue to exceed NII as well as our regular dividends, we may need to declare additional special dividends to meet our requirement as a tax-efficient regulated investment company to distribute 90% of our taxable income to shareholders.”
To us, we’re not interested in running out and adding a company that slashed its dividend to the Dividend Growth portfolio, nor do we think its BDC peers are worthy of consideration given that they are operating in the very same environment. Let’s just say that we pay close attention to Warren Buffett’s rule No. 1: Never lose money.
A list of BDCs: American Capital (), Apollo Investment (), Ares Capital (), Blackrock Kelso Capital (BKCC), CorEnergy (CORR), Equus (EQS), Fidus (FDUS), Fifth Street Finance (FSC), Full Circle (FULL), Gladstone Capital (GLAD), Golub (GBDC), Hercules Technology (HTGC), Horizon Technology (HRZN), KCAP Financial (KCAP), KKR Financial (KFN), Main Street (), MCG Capital (MCGC), Medley Capital (MCC), Monroe Capital (MRCC), MVC Capital (MVC), New Mountain (NMFC), NGP Capital Resources (NGPC), Oxford Lane (OXLC), Pennant Park (PNNT), Prospect Capital (), Solar Capital (SLRC), Stellus Capital (SCM), TCP Capital (TCPC), THL Credit (TCRD), TICC Capital (TICC), Triangle Capital (), Whitehorse Finance (WHF).