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Summary

  • Over the past few days, Prospect Capital has invested over $550 million via two separate first-lien senior secured debt transactions.
  • This marks a return for Prospect Capital to its typical modus operandi of investing in private company debt and equity.
  • The company had previously been focusing more on rental properties and other unrelated businesses in a search for IRR.
  • Concerns regarding ETFs selling BDCs has put increased selling pressure on Prospect Capital’s stock.
  • Prospect Capital remains a decent choice for income, with the stock now trading right around its NAV.

Prospect Capital (NASDAQ:PSEC) finally seems to be returning to form. The company is a business development company, or BDC, which typically invests in private company debt and equity. Over the past few months, Prospect Capital has seen its loan originations steadily tick higher, with a record $1.3 billion for Q1 2014. Prospect Capital also offers a significantly high monthly dividend of about $0.1104 per share, for an annualized yield of slightly under 12.30%.

Loan Originations are on the rise

As noted in the intro, Prospect Capital closed over $1.3 billion loan originations for its March 2014 quarter. This is a record amount for the company, well exceeding last quarter's $607.7 million and last year's $681.9 million.

Over the past two days, Prospect Capital announced two large investments into senior secured debt, its bread and butter. Below is a summary of the transactions:

  • $277.5 million of first-lien floating-rate debt to support the refinancing of IWCO Direct, a leading provider of direct marketing solutions. link
  • $279 million of first-lien senior secured debt and equity to recapitalize Harbortouch Payments, a leading provider of transaction processing services and point-of-sale ("POS") equipment. link

In regards to Harbortouch, Prospect Capital had previously been solely a lender, and has now shifted to become both a lender and a shareholder.

Prospect Capital is likely benefiting from a combination of increased demand for its capital as well as a cool down in the overall BDC market. In late 2013, many BDCs were flush with cash, oftentimes fiercely competing for the same loans and chasing ever smaller rate of returns. This increased competition may have led Prospect Capital to start investing large sums into non-core assets such as rental properties and auto lending.

However, this situation seems to have reversed this quarter, with Prospect Capital more than doubling its sequential loan originations. Indeed, the company was able to increase its lending without putting much strain on its balance sheet, given the large amounts of excess investment capacity available and a modest 48% debt to equity ratio. Due to this increased loan activity, Prospect Capital may also see an uptick in its NII this year.

Prospect Capital has declared dividends through September 2014, locking in income medium term

While increased loan originations are nice, most investors in Prospect Capital are in the stock for the monthly income. In this regard, Prospect Capital has not disappointed, declaring dividends through September 2014.

  • 11.0475 cents per share for July 2014 (record date of July 31, 2014 and payment date of August 21, 2014);

  • 11.0500 cents per share for August 2014 (record date of August 29, 2014 and payment date of September 18, 2014); and

  • 11.0525 cents per share for September 2014 (record date of September 30, 2014 and payment date of October 22, 2014).

  • These distributions mark Prospect's 72nd, 73rd, and 74th consecutive cash distributions to shareholders.

Over the past few quarters, the dividend payout ratio based on NII has remained slightly elevated, at or above 100%. While the company has increased its dividend every month, these increases have been microscopic.

However, given the increased pace of loan originations, Prospect Capital may be due for a meaningful dividend hike, likely in the low single-digit percentage range. Do note that any increase needs to be preceded by increases in NII per share. I suspect the company to not post an increase in this key metric until at least Q2 2014.

Prospect Capital is likely to trade around its NAV as ETFs sell off BDCs

Also note that Prospect Capital, like many other BDCs, has seen its share price stagnant due to Russell and S&P Dow Jones removing BDCs from their respective indices.

This move has caused a chain reaction of sorts, where ETFs that are linked to these indices being forced to become sellers of BDCs' stock. An estimated 8% of all BDC shares are held by ETFs linked to the Russell alone, with another sizable chunk held by S&P linked funds.

The cause for this move is simply expense ratios. Due to an antiquated SEC rule, ETFs are required to incorporate the added cost structure of BDCs to their own reported expense ratios.

While this requirement only increases the ratio by a few basis points, in the fiercely competitive world of ETFs, this was an unbearable burden.

As a result, I expect continued volatility in Prospect Capital's share price until June 2014, when the Russell completes it reconstitution. However, the Q4 2013 NAV of $10.73 should serve as a short-term floor for the share price.

Conclusion

While I am sure some will criticize Prospect Capital's underwriting standards, the simple fact is that the company has not had a loan go on non-accrual status in nearly 6 years.

With a yield over 12% (1% per month), Prospect Capital is a solid choice for income. However, do note that the stock will likely not offer any form of capital appreciation, given its frequent share dilution via its ATM program.

$1.3 billion for one quarter is an absolutely massive amount, representing over 25% of Prospect Capital's EV. Looking forward, Prospect Capital will likely see the benefits from its increased loan activity starting in Q2 2014.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Source: A Record Quarter For Prospect Capital