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Prospect Capital (PSEC) is a business development company (BDC) that lends to and invests in middle market privately-held companies. The company is a closed-end investment company. The company invests primarily in senior and subordinated debt and equity of companies in need of capital for acquisitions, divestitures, growth, development, project financing and recapitalization. PSEC pays out a monthly dividend of 10.16 cents per share, which translates to an annual yield of 10.6%.

On August 22nd, PSEC reported quarterly and full-year results. For the fiscal 2012 year, they had net investment income (NII) of 187 million, or $1.63 per share. Over the same time period, only $1.22 of this net income was returned to shareholders via the monthly dividend. By law, BDCs such as a PSEC are required to distribute 90% of their NII to shareholders. Thus, in order to comply with this rule, an additional $0.25 would need to be distributed to shareholders. This could be accomplished via a special one-time dividend. Alternatively, PSEC could also increase its monthly payout rate. The current dividend growth trend for PSEC is 0.0025 cents per share, or about 0.3% per year. Finally, there is also the possibility that PSEC can retain the undistributed NII by some type of accounting method (of which I am not an expert).

When asked about this on the latest conference call, management had this to say:

The more important payout requirement is the 90% related to preservation of RIC status which of courses is very important, and our intention is to continue being a non-tax paying RIC from that standpoint. And as you mentioned, spillover is something we can utilize where we can count distributions over the next several quarters towards the prior tax year distribution requirement.

We're actually in an August tax year, a slight offset from our fiscal, and which ends in about a week; and we would have to distribute I think it's by May, somewhere in that timeframe, Brian - in order to meet our distribution requirement for the August tax year. So we have plenty of time to meet that requirement. We're being very, very careful to make sure investors are seeing the dividend as a rock solid proposition.

Regardless of the ultimate fate of the undistributed NII, having the issue to begin with at all is most definitely a positive one. PSEC has by far the largest dividend coverage (NII to dividend amount ratio) in the BDC space. Some of PSEC's competitors include: Gladstone Capital (GLAD), Main Street Capital (MAIN), and Fifth Street Finance (FSC). The trailing four quarters payout ratios of each of the respective companies are shown in the table below.

CompanyTrailing 4Q NII (per share)Trailing Annual Payout (per share)Ratio
PSEC1.631.221.34
MAIN1.991.621.23
GLAD0.920.841.10
FSC1.131.1820.96

Given PSEC's strong quarterly results, coupled with its favorable payout ratio (that is, the dividend is more than covered by NII) and significant yield (10.6%), PSEC continues to remain a buy. Based on the significant percentage of undistributed NII, it is possible that PSEC will be announcing a special dividend and/or more substantial dividend increase in the coming months.

Source: High Probability Of A Special Dividend Or Dividend Increase From Prospect Capital