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Business development companies (BDCs) are a form of publicly traded private equity. They are required to distribute 90% of their taxable income to shareholders. As such, the majority of returns for shareholders comes in the way of dividends. In this article, I discuss four attributes of a successful BDC, and explain why Prospect Capital (PSEC) is one such fund.

1. Distributions covered by net investment income

The desire for this attribute is relatively straightforward. One wants to own a company that pays out less than it earns. Per the latest PSEC earnings release:

We have generated cumulative NII in excess of cumulative distributions to shareholders for both the current August 2012 tax year as well as since Prospect's initial public offering almost eight years ago.

2. Distribution at or above 10%

Since the majority of returns comes in the form of distributions, relatively large yields are necessary for sufficient returns. BDCs frequently raise debt and/or equity, so minimal returns can be expected via share price appreciation. I prefer BDCs around 10%. This yield is equivalent to the historical annualized return of the S&P 500.

The current yield on PSEC is 10.9%.

3. Maintaining a manageable cost of funds

The price at which a BDC can raise debt is a very important factor for net investment income, since the difference between yield on assets and cost of funds dictates the profitability of the company. The yield on a BDC loan portfolio is often in the low teens (closer to 10% than 15%, however).

For the quarters from 3/31/2011 through 12/31/2011, PSEC has featured a weighted yield on assets of 12.9%, 12.8%, 12.4%, and 12.2%. Over a similar time period, debt raises for PSEC have come in at 5.50%, 6.25%, and most recently, 5.375%. Thus, PSEC has been generating net margins on the order of 7%.

For comparison purposes, consider similar metrics from another BDC - Gladstone Capital (GLAD). Per the latest earnings release, GLAD featured yield on assets of 10.9%. Its latest debt offering came in at 7.125%, in the form of preferred stock. Thus, when compared to GLAD, PSEC features a much more desirable cost of funds.

4. Equity offerings above net asset value

For BDC investments, equity offerings are necessary since nearly all earnings get distributed to shareholders. These offerings are needed to keep the business going. Since BDCs typically feature high yields (and the majority of their returns come from these yields), any equity raise at levels above book value should be viewed as gravy. When this happens, you are increasing the net asset value on a per share basis in addition to your 10+% returns by way of dividends.

Over the past three stock issuances, PSEC has priced its stock above NAV two of those times - 10.95 (NAV at 10.69), 10.15 (NAV at 10.33), 12.18 (NAV at 10.25). The one black eye for PSEC on this front is that it did price an equity offering below NAV, albeit with a small differential.

Conclusion

I believe that the BDCs worth owning are those that meet all four criteria, as discussed above. I believe PSEC is one of those worth owning. An ideal entry point for PSEC is any price below the current NAV of 10.69.

Source: 4 Attributes Of A Business Development Company Worth Owning