UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 333-114552
PROSPECT ENERGY CORPORATION
(Exact name of registrant as specified in its charter)
Maryland
43-2048643
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
10 East 40th Street
New York, New York
10016
(Address of principal executive offices)
(Zip Code)
(212) 448-0702
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days.x Yeso No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).x Yeso No
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).o Yesx No
The number of shares of the registrant’s Common Stock, $0.001 par value, outstanding as of September 30, 2005 was 7,055,100.
PROSPECT ENERGY CORPORATION FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2005 TABLE OF CONTENTS
Page
PART I.
FINANCIAL INFORMATION
3
Item 1.
FINANCIAL STATEMENTS (unaudited)
Balance Sheets as of September 30, 2005 and June 30, 2005
Schedule of Investments as of September 30, 2005
4
Schedule of Investments as of June 30, 2005
6
Statements of Operations for the three months ended September 30, 2005, for the three months ended September 30, 2004 and for the twelve months ended June 30, 2005.
8
Statement of Stockholders’ Equity for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005
9
Statements of Cash Flows for the three months ended September 30, 2005, for the three months ended September 30, 2004 and for the twelve months ended June 30, 2005
10
Notes to Financial Statements
11
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
18
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
21
Item 4.
Controls and Procedures
22
PART II.
OTHER INFORMATION
23
Legal Proceedings
Unregistered Sales in Equity Securities and Use of Proceeds
24
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5.
Other Information
Item 6.
Exhibits
Signatures
25
2
PART I. FINANCIAL INFORMATION
In this Quarterly Report, “Company”, Prospect Energy”, “Fund”, “we”, “us” and “our” refer to Prospect Energy Corporation unless the context otherwise states.
Item 1. FINANCIAL STATEMENTS
PROSPECT ENERGY CORPORATION BALANCE SHEETS (in thousands, except share and per share amounts)
September 30, 2005
June 30, 2005
(unaudited)
Assets
Cash held in segregated account (Note 3)
$
9,587
Investment, Gas Solutions Holdings, Inc. at value (cost - $23,327 and $23,327, respectively, Note 3)
29,700
29,500
Investments, at value (cost - $63,917 and $64,197, respectively, Note 3)
63,962
64,366
Accrued interest receivable
502
206
Due from Gas Solutions Holdings, Inc. (Note 3)
7
201
Due from Investment Advisor (Note 5)
—
Due from Prospect Administration (Note 5)
14
Prepaid expenses
297
49
Total assets
104,072
103,909
Liabilities
Accrued liabilities
1,014
818
Due to Investment Advisor (Note 5)
16
77
Other current liabilities
13
47
Total liabilities
1,043
942
Commitments and contingencies (Notes 3 and 7)
Stockholders’ equity (Notes 1, 4 and 6)
Common stock, par value $.001 per share, 100,000,000 and 100,000,000 common shares authorized, respectively, 7,055,100 and 7,055,100 issued and outstanding, respectively
Paid-in capital in excess of par
96,955
Distributions in excess of net investment income
(351
)
(337
Net unrealized appreciation
6,418
6,342
Total stockholders’ equity
103,029
102,967
Total liabilities and stockholders’ equity
Net asset value per share
14.60
14.59
See notes to financial statements.
PROSPECT ENERGY CORPORATION SCHEDULE OF INVESTMENTS (unaudited)(in thousands, except share amounts)September 30, 2005
Portfolio Investments (1)
Locale / Industry
Principal Amount / Shares
Cost
Fair Value (2)
% of Net Assets
Gas Solutions Holdings, Inc. (4)
Texas/Gas gathering and processing
- Common shares
100
4,927
11,300
10.9
%
- Subordinated secured note, 18% 12/23/11
18,400
17.9
- Total
23,327
28.8
Unity Virginia Holdings, LLC (3)
Virginia/ Coal production
- Preferred stock, 100%, non-voting
585
0.6
- Subordinated secured note, 17.65%, 1/31/09
3,315
3,243
3,217
3.1
3,828
3,802
3.7
Stryker Energy II, LLC (3)
Ohio / Oil and gas production
- Preferred shares, Class B
539
0.5
- Common shares, Class A
931
0.9
- Senior secured note, 14.12%, 4/8/10
13,330
13,110
13,056
12.7
14,580
14,526
14.1
Whymore Coal (3)
Kentucky/ Coal production
-Preferred shares, Convertible, Series A
1,000
123
0.1
- Senior secured note, 15.00%, 3/31/09
5,810
5.7
-Total
5,933
5.8
Natural Gas Systems, Inc. (3)
Texas/Oil and gas production
- Warrants
210
135
- Senior secured note, 14.00%, 2/3/10
4,000
3,747
3,720
3.6
3,957
3,855
PROSPECT ENERGY CORPORATIONSCHEDULE OF INVESTMENTS (unaudited)(in thousands, except share amounts)September 30, 2005 (continued)
Miller Petroleum, Inc.(3)
Tennessee/Oil and gas production
- Warrants, Expires 5/4/10
630
150
240
0.2
- Senior secured note, 12.50%, 8/21/06
3,150
2,997
2.9
3,147
3,237
Worcester Energy Company, Inc. (3)
Maine/Wood processing and biomass power generation
- Preferred Shares, Convertible, Series A
15
0.0
- Senior secured note, 12.50%, 12/31/06
10,750
10,485
10.2
10,500
Arctic Acquisition Corporation (3)
Texas/Oilfield services
-Warrant, Expires 7/19/12
1
1.0
- Senior secured note, 13.00%, 6/15/2009
9,250
8,050
7.8
9,064
8.8
Total Portfolio Investments
74,198
80,616
78.2
U.S. Government Securities
Yield to Maturity
Federal Home Loan Bank Discount Note 10/6/2005
3.41
10,000
9,997
9.7
Money Market Fund
Shares
First American Prime Obligation Fund (Class Y)
3,049
3,048
3.0
Total Investments
87,244
93,662
90.9
(1) The securities in which Prospect Energy has invested were acquired in transactions that were exempt from registration under the Securities Act of 1933, as amended, or the “Securities Act”. These securities may be resold only in transactions that are exempt from registration under the Securities Act.
(2) Fair value is determined by or under the direction of the board of directors of Prospect Energy (Note 2).
(3) Non-control/non-affiliate position.
(4) Gas Solutions Holdings Inc. is a wholly owned and controlled investment of Prospect Energy.
5
PROSPECT ENERGY CORPORATION SCHEDULE OF INVESTMENTS(in thousands, except share amounts)June 30, 2005
11,100
10.8
28.7
3,210
3,795
947
8,330
8,177
7.9
9,647
9,663
9.3
4,885
4.7
5,008
4.8
175
3,729
3,746
3,939
3,921
3.8
PROSPECT ENERGY CORPORATIONSCHEDULE OF INVESTMENTS(in thousands, except share amounts)June 30, 2005 (continued)
365
0.4
2,730
2,778
2.7
3,095
3,143
48,688
55,030
53.5
U.S. Treasury Bill 7/7/05
2.52
5,518
5,516
5.4
U.S. Treasury Bill 7/14/05
2.49
9,514
9,505
9.2
U.S. Treasury Bill 7/21/05
2.55
22,261
22,226
21.6
Total US Government Securities
37,247
36.2
1,589
1.5
87,524
93,866
91.2
PROSPECT ENERGY CORPORATION STATEMENTS OF OPERATIONS (in thousands)
Three months ended September 30, 2005
Three months ended September 30, 2004
Twelve months ended June 30, 2005
Investment income
Interest income
1,361
266
1,882
Interest income, Gas Solutions Holdings, Inc.
828
2,704
Dividend income
196
284
Dividend income, Gas Solutions Holdings, Inc. (Note 3)
556
3,151
Other income
168
72
Total investment income
3,109
8,093
Operating expenses
Investment advisory fee (Note 5)
510
337
1,808
Administration costs (Note 5)
56
73
Legal fees (Note 3)
719
160
2,575
Valuation services
41
42
Other professional fees
122
230
Insurance expense
98
61
325
Directors’ fees
55
220
Organizational costs (Note 4)
General and administrative expenses
93
69
191
Total operating expenses
1,694
700
5,682
Net investment income (loss)
1,415
(434
2,411
Net realized loss
(18
(2
Net unrealized appreciation (depreciation)
76
(7
Net increase (decrease) in stockholders’ equity resulting from operations
1,473
(441
8,751
Basic and diluted net increase (decrease) in stockholders equity per common share resulting from operations (Note 6)
0.21
(0.09
1.24
PROSPECT ENERGY CORPORATION AND SUBSIDIARY STATEMENT OF STOCKHOLDERS’ EQUITY (in thousands, except share and per share amounts)
Common Stock
Paid in Capital in Excess of Par
Distributions in Excess of Net Investment Income/(Loss)
Net Unrealized Appreciation
Total Stockholders’ Equity
Amount
Balance, June 30, 2004
(100
(99
Issuance of common stock from public offering (net of underwriting costs)
7,055,000
98,417
98,424
Offering costs
(1,463
Net increase in stockholders’ equity resulting from operations for the year ended June 30, 2005
2,409
Dividends declared ($0.38 per share) and paid to stockholders
(2,646
Balance, June 30, 2005
7,055,100
Net increase in stockholders’ equity resulting from operations for the three months ended September 30, 2005 (unaudited)
1,397
Dividends declared ($0.20 per share) and paid to stockholders (unaudited)
(1,411
Balance, September 30, 2005 (unaudited)
PROSPECT ENERGY CORPORATION STATEMENTS OF CASH FLOWS (in thousands)
Cash flows from operating activities:
Net increase in stockholders’ equity resulting from operations
Adjustments to reconcile net increase in stockholders’ equity resulting from operations to net cash provided by (used in) operating activities:
Net unrealized appreciation (depreciation) on investments
(76
(6,342
Amortization of loan origination fees
(131
Change in operating assets and liabilities:
Purchases of investments
(939,046
(96,877
(701,630
Sale / refinancing of investments
939,457
614,106
Increase in prepaid expenses
(248
(299
(49
Increase in accrued interest receivable
(296
(157
(206
Decrease (increase) in due from Gas Solutions Holdings, Inc.
194
(201
Increase in due from Investment Advisor
(3
(53
Increase in due from Prospect Administration
(14
Increase in accrued liabilities
1,330
Increase (decrease) in other current liabilities
(34
50
Decrease in due to Investment Advisor
(61
(23
Net cash provided by (used in) operating activities
1,411
(96,540
(84,729
Cash flows from financing activities:
Net proceeds from the issuance of common stock
Offering costs from the issuance of common stock
Dividends declared and paid
Net cash provided by (used in) financing activities
96,961
94,315
Net increase in cash
421
9,586
Cash, beginning of period
Cash, end of period
422
PROSPECT ENERGY CORPORATION NOTES TO FINANCIAL STATEMENTS (unaudited) (in thousands except share and per share amounts)
Note 1. Organization and Interim Financial Statements
Prospect Energy Corporation (“Prospect Energy” or the “Company”), a Maryland corporation, was organized on April 13, 2004 and is a closed-end investment company that has filed an election to be treated as a business development company under the 1940 Act. On July 27, 2004, the Company completed its initial public offering and sold 7,000,000 shares of common stock at a price of $15.00 per share, less underwriting discounts and commissions totaling $1.05 per share. On August 27, 2004, an additional 55,000 shares were issued for a price of $15.00 per share, less underwriting discounts and commissions of $1.05 per share in connection with the exercise of an over-allotment option with respect to the offering.
Prospect Energy focuses primarily on investments in energy companies and will invest, under normal circumstances, at least 80.0% of its net assets (including the amount of any borrowings for investment purposes) in these companies. At September 30, 2005, 78.3% of its net assets were invested in energy companies with the remainder invested in U.S. government and money market securities. Prospect Energy is a non-diversified company within the meaning of the 1940 Act. Prospect Energy concentrates on making investments in energy companies having annual revenues of less than $250.0 million and in transaction sizes of less than $100.0 million. In most cases, these companies are privately held or have thinly traded public equity.
The accompanying financial statements are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, certain information and footnote disclosures normally included in audited financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the audited financial statements that were included in the Company’s form 10-K for the year ended June 30, 2005.
In the opinion of management, all adjustments (consisting primarily of normal recurring adjustments) have been made that are necessary to present fairly the financial position of the Company. Operating results for the interim periods presented are not necessarily indicative of the results to be expected for a full year.
Note 2. Significant Accounting Policies
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reported period. Changes in the economic environment, financial markets and any other parameters used in determining these estimates could cause actual results to differ.
The following are significant accounting policies consistently applied by Prospect Energy:
Investments:
(a) Security transactions are recorded on a trade-date basis.
(b) Valuation:
(1) Investments for which market quotations are readily available are valued at such market quotations.
(2) Short-term investments which mature in 60 days or less, such as U.S. Treasury bills, are valued at amortized cost, which approximates market value. The amortized cost method involves valuing
a security at its cost on the date of purchase and thereafter assuming a constant amortization to maturity of the difference between the principal amount due at maturity and cost. Short-term securities which mature in more than 60 days are valued at current market quotations by an independent pricing service or at the mean between the bid and ask prices obtained from at least two brokers or dealers (if available, or otherwise by a principal market maker or a primary market dealer). Investments in money market mutual funds are valued at their net asset value as of the close of business on the day of valuation.
(3) It is expected that most of the investments in the Company’s portfolio will not have readily available market values. Debt and equity securities whose market prices are not readily available are valued at fair value, with the assistance of an independent valuation service, using a valuation policy and a consistently applied valuation process which is under the direction of our board of directors.
As part of the fair valuation process, the Audit Committee reviews the preliminary evaluations prepared by the independent valuation firm engaged by the Board of Directors. Management and the independent valuation firm respond to the preliminary evaluation to reflect comments provided by the Audit Committee. The Audit Committee reviews the final valuation report and makes a recommendation to the Board of Directors based on its analysis of the methodologies employed and the various weights that should be accorded to each portion of the valuation as well as factors that the independent valuation firm and management may not have included in their evaluation process. The Board of Directors then evaluates the Audit Committee recommendations and undertakes a similar analysis to determine the fair value of each investment in the portfolio in good faith.
(c) Realized gains or losses on the sale of investments are calculated using the specific identification method.
(d) Interest income, adjusted for amortization of premium and accretion of discount, is recorded on an accrual basis.
(e) Dividend income is recorded on the ex-dividend date.
(f) Loan origination, facility, commitment, consent and other advance fees received by us on loan agreements or other investments are accreted into income over the term of the loan.
Federal and State Income Taxes:
Prospect Energy has elected to be treated as a regulated investment company and intends to continue to comply with the requirements of the Internal Revenue Code of 1986 (the “Code”), applicable to regulated investment companies. Prospect Energy is required to distribute at least 90% of its investment company taxable income and currently intends to distribute or retain through a deemed distribution all of its investment company taxable income and net capital gain to shareholders; therefore, we have made no provision for income taxes.
The character of income and gains that we will distribute is determined in accordance with income tax regulations that may differ from GAAP.
Dividends and Distributions:
Dividends and distributions to common stockholders are recorded on the ex-dividend date. The amount, if any, to be paid as a dividend is approved by the board of directors each quarter and is generally based upon management’s estimate of our earnings for the quarter. Net realized capital gains, if any, are distributed at least annually.
12
Consolidation:
As an investment company, Prospect Energy only consolidates subsidiaries which are also investment companies. At September 30, 2005, Prospect Energy did not have any consolidated subsidiaries.
Guarantees and Indemnification Agreements:
The Company follows FASB Interpretation Number 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” (“FIN 45”). FIN 45 elaborates on the disclosure requirements of a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing certain guarantees. FIN 45 did not have a material effect on the financial statements. Refer to Note 3 for further discussion of guarantees and indemnification agreements.
Note 3. Portfolio Investments
As required by the 1940 Act, we classify our investments by level of control. As defined in the 1940 Act, control investments are those where there is the ability or power to exercise a controlling influence over the management or policies of a company. Control is generally viewed to exist when a company or individual owns 25% or more of the voting securities of an investee company. Affiliated investments and affiliated companies are defined by a lesser degree of influence and are deemed to exist through ownership of an amount greater than 5% but less than 25% of the voting securities of the investee company. The Company owns 100% of the outstanding common equity shares of Gas Solutions Holdings, Inc. (“GSHI”) and therefore, has a controlling interest. The Company has no other controlled or affiliated investments.
GSHI has indemnified Prospect Energy against any legal action arising from its investment in Gas Solutions, LP. Prospect Energy has incurred approximately $0.420 million and $0.760 million in fees associated with this legal action for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005, respectively. GSHI has reimbursed Prospect Energy $1.173 million as of September 30, 2005. Prospect Energy has a receivable from GSHI of approximately $0.007 million and $0.201 million as of September 30, 2005 and June 30, 2005, respectively. The $0.420 million and $0.760 million reimbursement is reflected as dividend income, Gas Solutions Holdings, Inc. on the accompanying statement of operations for the three months ended September 30, 2005 and the twelve months ended June 30, 2005, respectively.
The Company has provided a limited indemnity to Citibank Texas, N.A. related to Citibank’s term loan to GSHI. The limited indemnity requires us to indemnify Citibank for up to $12.0 million if it realizes losses on the term loan related to certain claims. This limited indemnity is backed by segregated funds in Prospect Energy’s account valued at $9.6 million. During the quarter ended June 30, 2005, $3.3 million of previously segregated funds were released to the Company. This reduction reflects prior payments by GSHI to Citibank Texas, N.A. These funds are released upon the earlier of legal resolution of such claims, should any be made, or 91 days after the loan with Citibank Texas, N.A. is refinanced or otherwise repaid.
On December 6, 2004, Dallas Gas Partners, LP (“DGP”) served Prospect Energy with a Complaint filed November 30, 2004 in the United States District for the Southern District of Texas, Galveston Division. DGP alleges that DGP was defrauded and that Prospect Energy breached its fiduciary duty to DGP and tortiously interfered with DGP’s contract to purchase Gas Solutions, Ltd. (a subsidiary of our portfolio company, GSHI) in connection with Prospect Energy’s alleged agreement in September, 2004 to loan DGP funds with which DGP intended to buy Gas Solutions, Ltd. for approximately $26 million. The Complaint seeks relief not limited to $100 million (Note 7). We believe that the DGP Complaint is frivolous and without merit, and intend to defend the matter vigorously. However, as with any litigation, the outcome is uncertain and a judgment against Prospect Energy could significantly impair the value of the investment in Gas Solutions Holdings, Inc.
Debt placements and interests in non-voting equity securities with an original cost basis of $25.354 million were acquired during the three months ended September 30, 2005.
Note 4. Organizational and Offering Expenses
A portion of the net proceeds of our initial public offering and the subsequent exercise of the over-allotment option was used for organizational and offering expenses of approximately $0.125 million and $1.463 million, respectively. Organizational expenses were expensed as incurred. Offering expenses were charged against paid-in capital in excess of par. All organizational and offering expenses were borne by Prospect Energy.
Note 5. Related Party Agreements and Transactions
Investment Advisory Agreement
Prospect Energy has entered into an Investment Advisory Agreement with Prospect Capital Management LLC (the “Investment Adviser”) under which the Investment Adviser, subject to the overall supervision of Prospect Energy’s board of directors, will manage the day-to-day operations of, and provide investment advisory services to, Prospect Energy. For providing these services the Investment Adviser will receive a fee from Prospect Energy, consisting of two components--a base management fee and an incentive fee. The base management fee will be calculated at an annual rate of 2.00% on Prospect Energy’s gross assets (including amounts borrowed). For services rendered under the Investment Advisory Agreement during the period commencing from the closing of Prospect Energy’s initial public offering through and including the first six months of operations, the base management fee was payable monthly in arrears. Therefore, services rendered under the Investment Advisory Agreement, the base management fee is payable quarterly in arrears. Subsequently, the base management fee is calculated based on the average value of Prospect Energy’s gross assets at the end of the two most recently completed calendar quarters (the closing of Prospect Energy’s initial public offering was treated as a quarter end for these purposes) and appropriately adjusted for any share issuances or repurchases during the current calendar quarter. Base management fees for any partial month or quarter are appropriately pro rated.
The incentive fee has two parts. The first part, the income incentive fee, is calculated and payable quarterly in arrears based on Prospect Energy’s pre-incentive fee net investment income for the immediately preceding calendar quarter. For this purpose, pre-incentive fee net investment income means interest income, dividend income and any other income (including any other fees (other than fees for providing managerial assistance), such as commitment, origination, structuring, diligence and consulting fees and other fees that Prospect Energy receives from portfolio companies) accrued during the calendar quarter, minus Prospect Energy’s operating expenses for the quarter (including the base management fee, expenses payable under the Administration Agreement described below, and any interest expense and dividends paid on any issued and outstanding preferred stock, but excluding the incentive fee). Pre-incentive fee net investment income includes, in the case of investments with a deferred interest feature (such as original issue discount, debt instruments with payment in kind interest and zero coupon securities), accrued income that we have not yet received in cash. Pre-incentive fee net investment income does not include any realized capital gains, realized capital losses or unrealized capital appreciation or depreciation. Pre-incentive fee net investment income, expressed as a rate of return on the value of Prospect Energy’s net assets at the end of the immediately preceding calendar quarter, is compared to a “hurdle rate” of 1.75% per quarter (7% annualized). However, our Investment Adviser has voluntarily agreed that for each fiscal quarter after January 1, 2005, the quarterly hurdle rate will be equal to the greater of (a) 1.75% and (b) a percentage equal to the sum of the daily average of the “quoted treasury rate” for each month in the immediately preceding two quarters plus 0.50%. “Quoted treasury rate” means the yield to maturity (calculated on a semi-annual bond equivalent basis) at the time of computation for Five Year U.S. Treasury notes with a constant maturity (as compiled and published in the most recent Federal Reserve Statistical Release H). These calculations will be appropriately pro rated for any period of less than three months and
adjusted for any share issuances or repurchases during the current quarter. The voluntary agreement by the Investment Adviser that the hurdle rate be fluctuating for each fiscal quarter after January 1, 2005 (as discussed above) may be terminated by the Investment Adviser at any time upon 90 days’ prior notice. The net investment income used to calculate this part of the incentive fee is also included in the amount of the gross assets used to calculate the 2% base management fee. Prospect Energy pays the Investment Adviser an income incentive fee with respect to Prospect Energy’s pre-incentive fee net investment income in each calendar quarter as follows: (1) no incentive fee in any calendar quarter in which Prospect Energy’s pre-incentive fee net investment income does not exceed the hurdle rate; (2) 100% of Prospect Energy’s pre-incentive fee net investment income with respect to that portion of such pre-incentive fee net investment income, if any, that exceeds the hurdle rate but is less than 125% of the quarterly hurdle rate in any calendar quarter (8.75% annualized assuming a 7% annualized hurdle rate); and (3) 20% of the amount of Prospect Energy’s pre-incentive fee net investment income, if any, that exceeds 125% of the quarterly hurdle rate in any calendar quarter (8.75% annualized assuming a 7% annualized hurdle rate). These calculations are appropriately pro rated for any period of less than three months and adjusted for any share issuances or repurchases during the current quarter.
The second part of the incentive fee, the capital gains incentive fee, is determined and payable in arrears as of the end of each calendar year (or upon termination of the Investment Advisory Agreement, as of the termination date), and equals 20.0% of Prospect Energy’s realized capital gains for the calendar year, if any, computed net of all realized capital losses and unrealized capital depreciation at the end of such year. In determining the capital gains incentive fee payable to the Investment Adviser, Prospect Energy calculates the aggregate realized capital gains, aggregate realized capital losses and aggregate unrealized capital depreciation, as applicable, with respect to each of the investments in its portfolio. For this purpose, aggregate realized capital gains, if any, equals the sum of the differences between the net sales price of each investment, when sold, and the original cost of such investment since inception. Aggregate realized capital losses equal the sum of the amounts by which the net sales price of each investment, when sold, is less the original cost of such investment since inception. Aggregate unrealized capital depreciation equals the sum of the difference, if negative, between the valuation of each investment as of the applicable date and the original cost of such investment. At the end of the applicable period, the amount of capital gains that serves as the basis for Prospect Energy’s calculation of the capital gains incentive fee equals the aggregate realized capital gains less aggregate realized capital losses and less aggregate unrealized capital depreciation with respect to its portfolio of investments. If this number is positive at the end of such period, then the capital gains incentive fee for such period is equal to 20% of such amount, less the aggregate amount of any capital gains incentive fees paid in respect of its portfolio in all prior periods.
The Investment Advisory fees were $0.510 million and $1.808 million for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005, respectively; during these periods there were no incentive fees. At September 30, 2005 the Company owed the Investment Advisor $0.016 million in investment advisory base management fees as the final gross assets as of the prior quarter exceeded the estimated gross assets. Also, the Company was owed $0.003 million for legal costs that it paid on behalf of the Investment Advisor.
Administration Agreement
Prospect Energy has also entered into an Administration Agreement with Prospect Administration, LLC (“Prospect Administration”) under which Prospect Administration, among other things, provides administrative services and facilities for Prospect Energy. Prospect Administration has engaged EOS Fund Services LLC to serve as sub-administrator of Prospect Energy. For providing these services, Prospect Energy reimburses Prospect Administration for Prospect Energy’s allocable portion of overhead incurred by Prospect Administration in performing its obligations under the Administration Agreement, including rent, the fees of the sub-administrator for services provided with respect to Prospect Energy and Prospect Energy’s allocable portion of the compensation of its chief compliance officer and chief financial officer and their respective staffs. Prospect Administration also provides on Prospect Energy’s behalf managerial assistance to those portfolio companies to which Prospect Energy is required to provide such assistance. Prospect Administration is a wholly owned subsidiary of the Investment Adviser.
The Company reimbursed Prospect Administration $0.056 million and $0.266 million for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005, respectively, for services it provided to Prospect Energy at cost. The Company also reimbursed Prospect Administration for certain expenses which it initially funded on behalf of the Company. At September 30, 2005, the Company was owed $0.014 million for tax compliance fees that is paid on behalf of Prospect Adminstration.
Managerial Assistance
As a business development company, we offer, and must provide upon request, managerial assistance to certain of our portfolio companies. This assistance could involve, among other things, monitoring the operations of our portfolio companies, participating in board and management meetings, consulting with and advising officers of portfolio companies and providing other organizational and financial guidance. We have received no fees and $0.077 million for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005, respectively, of these assistance fees from GSHI. These fees are paid to the Investment Advisor.
Note 6. Financial Highlights
The following is a schedule of financial highlights for the three months ended September 30, 2005 and for the twelve months ended June 30, 2005:
For the three months ended September 30, 2005
For the twelve months ended June 30, 2005
Per share data (1):
Net asset value at beginning of period
(0.01
Proceeds from initial public offering
13.95
Costs related to the initial public offering
(0.21
Net investment income
0.20
0.34
0.01
0.90
(0.20
(0.38
Net asset value at end of period
Per share market value at end of period
13.35
12.60
Current yield on long-term investments
19.05
21.25
Total return based on market value (2)
7.54
(13.46
)%
Total return based on net asset value (2)
1.44
7.40
Shares outstanding at end of period
Ratio/supplemental data:
Net assets at end of period (in thousands)
Annualized ratio of operating expenses to average net assets
6.99
5.52
Annualized ratio of net operating income to average net assets
5.50
8.50
(1) Financial highlights as of September 30, 2005 and June 30, 2005 are based on 7,055,100 shares outstanding.
(2) Total return based on market value is based on the change in market price per share between the opening and ending market prices per share in each period and assumes that dividends are reinvested in accordance with Prospect Energy’s dividend reinvestment plan. Total return based on net asset value is based upon the change in net asset value per share between the opening and ending net asset values per share in each period and assumes that dividends are reinvested in accordance with Prospect Energy’s dividend reinvestment plan. The total return is not annualized.
Note 7. Litigation
The Company is a defendant in two legal actions arising out of its activities. While predicting the outcome of litigation is inherently very difficult, and the ultimate resolution, range of possible loss and possible impact on operating results cannot be reliably estimated, management believes, based upon its understanding of the facts and the advice of legal counsel, that it has meritorious defenses for both actions. We intend to defend both of these actions vigorously, and believe that resolution of these actions will not have a materially adverse effect on the Company’s financial position.
On December 6, 2004, Dallas Gas Partners, LP (“DGP”) served Prospect Energy with a Complaint filed November 30, 2004 in the United States District for the Southern District of Texas, Galveston Division. DGP alleges that DGP was defrauded and that Prospect Energy breached its fiduciary duty to DGP and tortiously interfered with DGP’s contract to purchase Gas Solutions, Ltd. (a subsidiary of our portfolio company, GSHI) in connection with Prospect Energy’s alleged agreement in September 2004 to loan DGP funds with which DGP intended to buy Gas Solutions, Ltd. for approximately $26 million. The Complaint seeks relief not limited to $100 million. On August 9, 2005, we filed our Motion for Summary Judgment requesting dismissal of the DGP suit in its entirety based on a written agreement dated September 23, 2004 that Prospect and the partners of DGP negotiated under which Prospect paid $2.5 million and reimbursed all of DGP’s expenses totaling over $1.5 million in return for an assignment of DGP’s contract to purchase Gas Solutions, Ltd., and the parties exchange of mutual releases. We believe that the DGP Complaint is frivolous and without merit, and intend to defend the matter vigorously.
On April 7, 2005 a former officer of the Company filed a complaint with the Occupational Safety and Health Administration of the Department of Labor (“OSHA”) alleging discrimination, retaliation, infliction of emotional distress and other claims. This officer seeks economic reinstatement and other relief. On September 15, 2005, OSHA issued findings, including an order dismissing this complaint. The complainant has filed written objections to the order and has requested a hearing before an Administrative Law Judge. The Company does not believe that these claims, even if ultimately resolved against the Company, would be material. The Company believes the complaint is frivolous and without merit and intends to defend itself vigorously.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
This quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause the results of Prospect Energy Corporation to differ materially from those expressed or implied by such forward-looking statements. All statements other than statements of historical fact are statements that could be deemed forward-looking statements, including any projections of revenue, expenses, earnings or losses from operations or investments, or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements of expectation or belief; and any statements of assumptions underlying any of the foregoing. The risks, uncertainties and assumptions referred to above include risks that are described from time to time in our Securities and Exchange Commission, or the “SEC”, reports filed before this report.
The forward-looking statements included in this quarterly report represent our estimates as of the date of this quarterly report. We specifically disclaim any obligation to update these forward-looking statements in the future. Some of the statements in this quarterly report constitute forward-looking statements, which relate to future events or our future performance or financial condition. Such forward-looking statements contained in this quarterly report involve risks and uncertainties.
We use words such as “anticipates,” “believes,” “expects,” “future,” “intends” and similar expressions to identify forward-looking statements. Our actual results could differ materially from those projected in the forward-looking statements for any reason. We caution you that forward-looking statements of this type are subject to uncertainties and risks, many of which cannot be predicted or quantified.
The following analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes thereto contained elsewhere in this Form 10-Q.
Overview
Prospect Energy was incorporated under the Maryland General Corporation Law in April 2004. We have elected to be treated as a business development company under the Investment Company Act of 1940, as amended (the “1940 Act”). Accordingly, we are required to comply with certain regulatory requirements. For instance, we generally have to invest at least 70% of our total assets in “qualifying assets,” including securities of private or thinly traded public U.S. companies, cash, cash equivalents, U.S. government securities and high-quality debt investments that mature in one year or less.
We completed our initial public offering on July 30, 2004. As of September 30, 2005, we continue to pursue our investment strategy and 78.2% of our net assets are invested in energy companies, with the remainder invested in U.S. government and money market securities.
We invest in companies in the energy industry, most of which have relatively short or no operating histories. These companies are and will be subject to all of the business risk and uncertainties associated with any new business enterprise, including the risk that these companies may not reach their investment objective and the value of our investment in them may decline substantially or fall to zero.
Our portfolio generated an annualized current yield of 19.1 % and 21.3% as of September 30, 2005 and as of June 30, 2005, respectively, across all our long-term debt and equity investments. This yield includes interest from all of our long-term investments as well as dividends from GSHI and Unity Virginia Holdings. We expect this number to decline over time as we become fully invested. Monetization of, or dividends from, other equity positions that we hold is not included in this yield estimate.
Results of Operations
Results comparisons to the quarter ended September 30, 2004 may not necessarily be meaningful as our portfolio was largely invested in cash equivalents from our initial IPO in July of 2004. Accordingly, references and comparisons are made against our previous quarter ended June 30, 2005 in addition to the quarter ended September 30, 2004.
Investment Activity
We completed our fourth full quarter of operations since completion of our initial public offering on July 30, 2004, with approximately 9.7% of our net assets invested in obligations of the Federal Home Loan Bank; 78.2% or about $80.6 million in eight long-term portfolio investments; and 3.0% in a money market fund. The remaining 9.0% was comprised of 9.3% in the segregated account described below and (0.3%) in liabilities in excess of other assets.
Long-Term Portfolio Investments
During the quarter ended September 30, 2005, we completed two new investments totaling approximately $19.5 million in Worcester Energy Corporation (“WECO”) and Arctic Acquisition Corporation (“Arctic”) and two follow-on fundings totaling approximately $5.9 million in Whymore Coal Company (“Whymore”) and Stryker II Energy, LLC (“Stryker”).
On July 19, 2005, we provided $9.0 million of senior secured debt financing to Arctic Acquisition Corp. (“Arctic”) alongside $6.8 million of equity from Petro Capital IV, LP, of Dallas, Texas. The funding was used by Arctic to acquire the business and assets of Arctic Recoil, Inc., and to provide working and expansion capital to Arctic. As part of this investment, we also received an equity position in Arctic. Arctic is a privately owned and operated oilfield services company based in Houston, Texas that provides drillers with equipment that includes coiled tubing units, nitrogen pumps, fluid power pumps, trucks, cranes, and trailers. Arctic also specializes in high pressure coiled tubing workovers. Coiled tubing is one of the faster growing segments of the oilfield services sector, with applications such as wellbore cleanouts, acid stimulations, fracing, drilling, and logging.
On August 10, 2005, we provided an additional $0.6 million of senior secured debt financing to Whymore. On September 22, 2005, we further provided an additional $0.3 million of senior secured debt financing to Whymore.
On September 15, 2005, we provided an additional $5.0 million of senior secured debt financing to Stryker.
On September 28, 2005 we provided $10.5 million of senior secured debt financing to Worcester Energy Partners, Inc. (“WECO”), a wood processing and biomass power generation business based in Deblois, Maine. WECO is a privately owned renewable energy company that operates a wood harvesting and
19
chipping business as well as a newly refurbished 25.85 megawatt wood-fired power plant. Built in 1988, the plant has operated intermittently over the past decade and recently has been recommissioned for baseload operations. The wood harvesting and chipping business has access to more than 16,000 acres of wood fuel, and the plant has long-term contracts for the sale of electricity as well as renewable energy credits. Prospect’s funding has been utilized to refinance existing debt and to provide working capital to re-initiate plant operations. Prospect is receiving an equity position in WECO as part of the investment, including a minimum internal rate of return on Prospect’s investment.
Investment Income
We generate revenue in the form of interest income on the debt securities that we own, dividend income on any common or preferred stock that we own, and capital gains or losses on any debt or equity securities that we acquire in portfolio companies and subsequently sell. Our investments, if in the form of debt securities, will typically have a term of one to ten years and bear interest at a fixed or floating rate. To the extent achievable, we will seek to collateralize our investments by obtaining security interests in our portfolio companies’ assets. We also may acquire minority or majority equity interests in our portfolio companies, which may pay cash or in-kind dividends on a recurring or otherwise negotiated basis. In addition, we may generate revenue in other forms including commitment, origination, structuring or due diligence fees; fees for providing managerial assistance; and possibly consultation fees. Any such fees generated in connection with our investments are recognized as earned.
Investment income, which consists of interest income, dividend income, and origination fee accretion totaled $3.1 million for the quarter ended September 30, 2005 compared to $2.7 million for the quarter ended June 30, 2005 and $0.3 million for the quarter ended September 30, 2004. Interest income increased by 22.6% quarter-over-quarter as a result of interest received from one additional portfolio investment in Arctic, as well as two follow-on fundings made to Stryker and Whymore during the quarter and described earlier. The remaining investment income during the three months ended September 30, 2005 was generated primarily from investments in short-term United States Treasury Bills, Federal Home Loan Bank Discount Notes and cash equivalents.
Operating Expenses
Our primary operating expenses consist of investment advisory fees, legal and professional fees and other operating and overhead-related expenses. These expenses include our allocable portion of overhead under the Administration Agreement with Prospect Administration under which Prospect Administration provides administrative services and facilities for Prospect Energy. Our investment advisory fees compensate our Investment Adviser for its work in identifying, evaluating, negotiating, closing and monitoring our investments. We bear all other costs and expenses of our operations and transactions in accordance with our Administration Agreement with Prospect Administration.
Operating expenses totaled $1.7 million for the quarter ended September 30, 2005 as compared to $1.9 million for the quarter ended June 30, 2005 and $0.7 million for the quarter ended September 30, 2004. These expenses consisted of investment advisory and administrative services fees, professional fees, insurance expenses, directors fees and other general and administrative expenses. The base investment advisory fees totaled $0.5 million for the quarter ended September 30, 2005 compared to $0.5 million for the quarter ended June 30, 2005 and $0.3 million for the quarter ended September 30, 2004. No incentive
20
fee has yet been incurred pursuant to the Investment Advisory Agreement. Legal and professional fees were higher during the three months ended September 30, 2005 than we would expect in future periods due to the occurrence of certain items and their associated costs which we would not expect to occur at this level in the future, including litigation-related costs.
Net Investment Income, Net Unrealized Appreciation and Net Increase in Stockholders’ Equity Resulting from Operations
Prospect Energy’s net investment income totaled $1.4 million for the quarter ended September 30, 2005 compared to $1.2 million for the quarter ended June 30, 2005 and ($0.4) million for the quarter ended September 30, 2004. Net investment income represents the difference between investment income and operating expenses and is directly impacted by the items described above. Net unrealized appreciation totaled $0.1 million for the quarter ended September 30, 2005 compared to $5.9 million for the quarter ended June 30, 2005 and $0.0 million for the quarter ended September 30, 2004, primarily as a result of the increase in fair value of our investment in GSHI. Net increase in stockholders’ equity resulting from operations represents the sum of the returns generated from net investment income, realized gains (losses) and from unrealized appreciation (depreciation).
Financial Condition, Liquidity and Capital Resources
The Company’s liquidity and capital resources were generated primarily from the remaining net proceeds of its initial public offering as well as from cash flows from operations. We generated $97.0 million in cash from the net proceeds of our initial offering. We also generated cash flows from operations totaling $1.4 million for the quarter ended September 30, 2005 compared to $1.2 for the quarter ended June 30, 2005 and ($0.4) million for the quarter ended September 30, 2005. We declared and paid dividends totaling $1.4 million for the quarter ended September 30, 2005 compared to $1.1 million for the quarter ended June 30, 2005 and $0.0 million for the quarter ended September 30, 2004. In the future, we may also fund a portion of our investments through borrowings from banks, issuances of senior securities or secondary offerings. We may also securitize a portion of our investments in mezzanine or senior secured loans or other assets. We have initiated discussions with providers of commercial credit with respect to a syndicated commercial credit facility which, together with other borrowings (which may include reverse repos and similar transactions), may be used in the future to leverage our capital. Our objective is to put in place such borrowings in order to expand our portfolio. Our primary use of funds will be investments in portfolio companies and cash distributions to holders of our common stock.
At September 30, 2005, we had $9.6 million in cash held in a segregated account in conjunction with a limited indemnity issued to Citibank Texas, N.A. (formerly First American Bank, SSB). The limited indemnity with Citibank requires us to indemnify Citibank for up to $12.0 million for any losses it realizes on its term loan to GSHI resulting only from potential legal claims that might or could be asserted by certain third parties. These funds are to be released after the earlier of final legal resolution of such claims, should any be made, or 91 days after the Citibank loan is refinanced or otherwise repaid.
Item 3. Quantitative and Qualitative Disclosures about Market Risk.
We are subject to financial market risks, including changes in interest rates, equity price risk and some of the loans in our portfolio may have floating rates. To date, a significant, but declining, percentage of our assets have been and are invested in short-term U.S. Treasury bills. We may hedge against interest rate
fluctuations by using standard hedging instruments such as futures, options and forward contracts subject to the requirements of the 1940 Act. While hedging activities may insulate us against adverse changes in interest rates, they may also limit our ability to participate in the benefits of higher interest rates with respect to our portfolio of investments. During the three months ended September 30, 2005 and the twelve months ended June 30, 2005, we did not engage directly in hedging activities.
Item 4. Controls and Procedures.
As of the end of the period covered by this report, Prospect Energy carried out an evaluation, under the supervision and with the participation of Prospect Energy’s management, including Prospect Energy’s chief executive officer and chief financial officer, of the effectiveness of the design and operation of Prospect Energy’s disclosure controls and procedures (as defined in Rule 13a-15 of the Securities Exchange Act of 1934). Based on that evaluation, as of October 31, 2005, the chief executive officer and the chief financial officer have concluded that Prospect Energy’s current disclosure controls and procedures are effective in timely alerting them of material information relating to Prospect Energy that is required to be disclosed by Prospect Energy in the reports it files or submits under the Securities Exchange Act of 1934.
Internal Control Over Financial Reporting
Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over financial reporting, as such responsibility is defined in Rule 13a-15(f) of the Securities Exchange Act of 1934, and for performing an assessment of the effectiveness of internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Prospect Energy’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, thought not eliminate, this risk.
At March 31, 2005, Prospect Energy’s wholly owned portfolio company, GSHI, paid certain legal fees associated with Prospect’s restructuring of the GSHI transaction in the amount of $0.414 million. At the time, Prospect Energy’s management made the determination that these legal fees should not be reimbursed to their wholly owned subsidiary, in effect triggering a distribution. This distribution was deemed to be a return of capital, reducing Prospect Energy’s basis in GSHI without determining the cumulative earnings of GSHI as defined by GAAP and whether the distribution was a dividend. Management has since conducted an analysis of the cumulative GAAP earnings of GSHI and has determined that the distribution was indeed a return of capital and that the Company appropriately reduced its basis in GSHI. At June 30, 2005, Prospect Energy was reimbursed for $0.559 million and was owed $0.201 million of legal fees with respect to the Dallas Gas Partners Litigation (Note 7). The reimbursement is not considered an arms length transaction, in effect triggering a distribution. This distribution was deemed to be an expense
reimbursement, reducing Prospect Energy’s Legal Fees, not as a distribution which requires a determination of the cumulative earnings of GSHI as defined by GAAP and whether the distribution was a dividend. Management has since conducted an analysis of the cumulative GAAP earnings of GSHI and has determined that the distribution was indeed a dividend and that the Company had to increase its dividend income and legal fees. Management has mitigated this control weakness by preparing a monthly analysis of GSHI’s cumulative GAAP earnings.
There have been no changes in Prospect Energy’s internal control over financial reporting that occurred during the three months ended September 30, 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
On April 7, 2005 a former officer of the Company filed a complaint with the Occupational Safety and Health Administration of the Department of Labor (“OSHA”) alleging discrimination, retaliation, infliction of emotional distress and other claims. This officer seeks economic reinstatement and other relief. The Company does not believe that these claims, even if ultimately resolved against the Company, would be material. The Company believes the complaint is frivolous and without merit and intends to defend itself vigorously. On September 15, 2005, OSHA issued findings, including an order dismissing the complaint. The complainant may file written objections to the order and request a hearing before an Administrative Law Judge.
We are not aware of any other material pending legal proceeding, and no such material proceedings are known to be contemplated, to which we are a party or of which any of our property is subject.
Item 2. Unrealized Sales of Equity Securities and Use of Proceeds.
Not Applicable
Item 3. Defaults Upon Senior Securities.
Not Applicable.
Item 4. Submission of Matters to a Vote of Security Holders.
Item 5. Other Information.
Item 6. Exhibits
Exhibit No.
Description of Exhibit
31.1
Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)
31.2
Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/l5d-14(a)
32.1
Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. 1350
32.2
Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. 1350
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(Registrant)
Dated: November 14, 2005
By:
/s/ John F. Barry III
John F. Barry III
Chief Executive Officer and Chairman of the
Board of Directors