Prospect Capital's Dividend And NAV Sustainability Analysis - Part 2 (Including November 2016-January 2017 Dividend Projections)

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Summary

Part 2 of this article discusses three topics/trends impacting PSEC’s future dividend and NAV sustainability.

These three topics/trends discuss PSEC’s weighted average cash LIBOR floor, a FMV investment rating analysis, and a quarterly FMV percentage analysis on specific portfolio companies.

Due to recent macroeconomic events, performing the three analyses greatly assists investors make a more informed decision when considering PSEC as a possible equity investment.

My exact PSEC dividend per share projection for November 2016-January 2017 is stated in the “Conclusions Drawn” section of the article.

Along with my BUY, SELL, or HOLD recommendation and price target, this article provides some updated positive and negative catalysts/factors to consider when choosing PSEC as a possible equity investment.

Author's Note: PART 2 of this article is a continuation from PART 1 which was discussed in a previous publication. Please see PART 1 of this article for an initial discussion on the near-term dividend sustainability of Prospect Capital Corp. (NASDAQ:PSEC). PART 1 helps lead to a better understanding of the topics/trends that will be discussed in PART 2. The link to PART 1's analysis is provided below:

Prospect Capital Corp.'s Dividend and NAV Sustainability Analysis (Pre Fiscal Q1 2017 Earnings) - Part 1

This two-part article is a very detailed look at PSEC's dividend and net asset value ("NAV") sustainability. I have performed this analysis due to the number of readers who have specifically requested such an analysis be performed on PSEC at periodic intervals. For readers who just want the summarized conclusions/results, I would suggest to scroll down to the "Conclusions Drawn" section at the bottom of each part of the article.

Focus of PART 2 of Article:

PART 1 of this article mainly analyzed PSEC's past and current performance regarding the company's quarterly NII, cumulative undistributed NII, net ICTI, and cumulative UTI figures (including four tests being performed). PART 2 will transition to a more "forward-looking" dividend sustainability analysis and will discuss some additional topics/trends to consider in a general net increasing (and at times decreasing) interest rate environment that may counter (or confirm) the evidence obtained within PART 1. PART 2 will also perform an analysis on PSEC's future NAV sustainability. At the end of this article, I will include the following PSEC projections: 1) next set of monthly dividend declarations (per share rate for November 2016-January 2017); and 2) NAV per share range for the next several quarters. In addition to my BUY, SELL, or HOLD recommendation and current price target, I will also provide some positive and negative catalysts/factors to consider when choosing PSEC as a possible equity investment.

Additional Topics/Trends Impacting PSEC's Future Dividend and NAV Sustainability:

In addition to the four tests performed in PART 1 of this article, the following three topics/trends will play an important role regarding PSEC's future dividend and NAV sustainability: 1) an in-depth analysis on how the company's investment portfolio is currently set up for a rise in the current/spot "London Interbank Offered Rate" (LIBOR) over the next several years; 2) a fair market value ("FMV") investment rating analysis on the company's debt and equity investments over the prior five quarters; and 3) a quarterly FMV percentage analysis on specific portfolio companies over the prior six quarters.

Prior to discussing the three topic/trends stated above, let me provide some general examples of how PSEC's investment portfolio can have income and valuation fluctuations over time. Income fluctuations have a direct impact on PSEC's future dividend sustainability. Valuation fluctuations have a direct impact on PSEC's future NAV sustainability (with some variables "intertwining"). I believe providing some general examples will be beneficial for most readers.

Through "Generally Accepted Accounting Principles" ("GAAP"), quarterly FMV "write-downs" (also known as capital depreciation) or "write-ups" (also known as capital appreciation) occur. Quarterly FMV fluctuations are also known as "mark-to-market" adjustments. These FMV fluctuations have an immediate and direct impact on PSEC's future NAV sustainability. When there is a market sell-off within global debt markets (heightened volatility), including certain pockets such as institutional/corporate and high-yield bonds, there is heightened spread/basis risk which negatively impacts bids for these types of investments. As such, lower bids typically occur in regards to these investments which directly lead to capital depreciation being recorded. In addition, if a portfolio company starts to see slowing operations and/or net losses, a FMV write-down would likely occur on PSEC's debt investment due to a perceived increase in credit risk (decrease in projected future cash flows). As such, the value of PSEC's investment portfolio would be reduced causing an immediate drop to earnings per share ("EPS"). This occurs even if the write-down is still unrealized. Let us now assume this same portfolio company begins to show signs of the inability to pay its loan obligations. This would cause PSEC's debt investment within that portfolio company to be put on "non-accrual" status (non-performance). When this occurs, interest income would stop being accrued as interest payments are not being received. As such, this would cause an immediate drop in PSEC's NII/net ICTI and have a direct impact on PSEC's future dividend sustainability.

These same general risks could also occur regarding PSEC's equity investments. If a portfolio company (which PSEC has an equity investment in) starts to see slowing operations and/or net losses, PSEC's equity investment would generally be deemed less valuable. As such, a FMV equity write-down/capital depreciation would occur. In a "worst case scenario", a total write-off would be necessary leaving PSEC's equity investment worthless. Similar to the debt investment example above, this would cause an immediate drop to EPS. As such, this would have an immediate and direct impact on PSEC's future NAV sustainability. If a portfolio company (which PSEC has an equity investment in) begins to show signs of an inability to pay its loan obligations (whether with PSEC or to a third party), PSEC's equity investment in that company would most likely see a reduction in dividend income (where applicable). If this were to occur, there would be an increased probability that some or all of the cash distributions received by PSEC from the portfolio company would be deemed a "return of capital" ("ROC") per GAAP/the "Internal Revenue Code" ("IRC") and thus not a component of NII/net ICTI. This would be determined by the "earnings and profit" (E&P; an IRC term) of the underlying operating companies. As such, this would cause an immediate drop to PSEC's NII/net ICTI and have a direct impact on PSEC's future dividend sustainability.

With that being said, let us now perform an in-depth analysis on how PSEC's investment portfolio is currently set up for a rise in current/spot LIBOR over the next several years.

1) Rise in Current/Spot LIBOR and the Impact on PSEC's Investment Portfolio:

There have been many readers who have continued to ask about this first topic/trend via both private and public correspondence. From these conversations, I have come to the conclusion some readers are having trouble understanding what will occur to PSEC's interest income and expense accounts as the Federal Open Market Committee ("FOMC") eventually continues to increase the Federal ("Fed") Funds Rate. In particular, this topic will analyze PSEC's "cash LIBOR floor" associated with most of the company's debt investments. While not having an immediate, material impact on PSEC's NII/net ICTI, I still believe a discussion of this topic/trend should be provided since this event will eventually have more of an impact on the company's future dividend sustainability (forward-looking metric). As the Fed Funds Rate continues to increase in the future, this event will have varying impacts on the BDC sector which is dependent on each company's weighted average cash LIBOR floor, percentage of floating-rate debt investments, and percentage of floating-rate liabilities.

Let us first take a look at the 1-, 3-, 6-, and 12-month current/spot LIBOR percentages during PSEC's fiscal first quarter of 2017 (quarter ending 9/30/2016). This will help put things in better perspective when analyzing PSEC's weighted average cash LIBOR floor.

Table 3 - Current/Spot LIBOR Percentages for PSEC's Fiscal First Quarter of 2017

(Source: Table created entirely by myself, obtaining current/spot LIBOR data via private access to a professional resource [Thomson Reuters])

Using Table 3 above as a reference, readers can see the 1-month LIBOR tenor/maturity had a minor increase, the 3-month LIBOR tenor/maturity had a modest increase, and the 6- and 12-month LIBOR tenors/maturities had a material increase during PSEC's fiscal first quarter of 2017. As discussed within my mortgage real estate investment trust (mREIT) articles, there is a high correlation between the movement of the Fed Funds Rate and current/spot LIBOR. Since the FOMC did not increase the Fed Funds Rate during the calendar third quarter of 2016, the effective Fed Funds Rate and 1-month current/spot LIBOR "followed suit" by basically maintaining rates or having a small increase. However, notice what occurred specifically in the 6- and 12-month current/spot LIBOR tenors/maturities. Simply put, markets are anticipating the FOMC will likely increase the Fed Funds Rate in late 2016/early 2017; hence the notable increase in 6- and 12-month current/spot LIBOR during PSEC's fiscal first quarter of 2017. As of 9/30/2016, 1-, 3-, 6-, and 12-month current/spot LIBOR increased 0.07%, 0.20%, 0.32%, and 0.32% when compared to 6/30/2016 (rounded to the nearest hundredth of a percentage). This was in stark contrast to what occurred during the prior quarter as, at the time, a Fed Funds Rate increase was unlikely during 2016 due to global and macroeconomic events.

While market participants continue to debate the most suitable course of action when it comes to the Fed's monetary policy, most would agree some sort of slow, gradual rise to this rate will occur (since current percentages continue to be near historical lows). As such, this analysis will assume an incremental, gradual rise in current/spot LIBOR across all maturities over the next several years. For PSEC (and the BDC sector as a whole), a gradual rise in current/spot LIBOR has two general impacts.

First, this would positively impact the sector's new loan originations that would most likely have higher stated interest rates when compared to existing fixed-rate debt investments. While this assumption will not come to fruition in "every" possible scenario, a majority of scenarios would have this type of outcome. Of course, factors like credit/spread risk come into play regarding this scenario but we will remain focused on specific LIBOR implications. During 2012-2014, most new loan originations within similar debt classifications (1st/ 2nd lien senior secured loans, subordinated/unsecured loans, structured securitizations, etc...) continued to experience a gradual decrease in the average interest rate charged on new investments due to falling interest rates across broader markets, general market conditions, and increased competition within the BDC sector. This includes competition within the lower middle market ("LMM"), middle market ("MM"), and upper middle market ("UMM"). This is known as "yield compression" and negatively impacted most BDC peers during this time frame, including PSEC. To show the extent of PSEC's yield compression during 2012-2014 (technically, the company's weighted average annualized yield on its debt investments), Table 4 is provided below.

Table 4 - PSEC Quarterly Weighted Average Annualized Yield Analysis (6/30/2012 - 6/30/2016; Evidence of Prior Yield Compression)

(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database)

Using Table 4 above as a reference, as of 6/30/2012 PSEC had a weighted average annualized yield on the company's debt investments of 13.9%. Through a gradual decline (a few quarters contradicted this notion), PSEC's weighted average annualized yield modestly decreased to 11.9% as of 9/30/2014. PSEC's mounting cumulative quarterly net decrease to the company's weighted average annualized yield basically caused a gradual decrease to its quarterly NII (generally speaking; several quarters had exceptions). However, this general trend reversed course during the calendar year 2015 which continued through the beginning of the calendar second quarter of 2016. PSEC's weighted average annualized yield increased from 11.9% as of 9/30/2014 to 13.4% as of 3/31/2016. While part of this increase was due to portfolio "shifts" per se, a large part of the increase was also a result of spreads widening within the MM/UMM. In addition, the continued gradual increase in current/spot LIBOR should continue to reverse the spread compression that occurred during 2012-2014 (even with the slight yield decrease that occurred during the calendar second quarter of 2016).

Second, this would negatively impact the sector's floating-rate credit facilities (which have a low fixed interest rate and LIBOR attachment) and a few other forms of debt financing. The BDC sector has continued to have low costs of capital regarding credit facilities as current/spot LIBOR has continued to remain near historical lows. However, with a rise in current/spot LIBOR, all floating-rate liabilities will also begin to have increased interest rates. With that being said, on a net basis, after current/spot LIBOR rises above certain thresholds, each BDC would eventually benefit from this rise. This is due to the fact each BDC's floating-rate debt investments (assets) generally have a greater monetary value versus each company's floating-rate debt borrowings (liabilities).

For purposes of this analysis, we will focus on the cash LIBOR floor of PSEC's existing floating-rate debt investments as of 6/30/2016. By performing this analysis, readers will begin to better understand some of the general implications a rise in current/spot LIBOR will have on PSEC's current investment portfolio (which would directly impact the company's future dividend sustainability).

Table 5 - PSEC Weighted Average Cash LIBOR Floor Analysis (As of 6/30/2016)

(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database [link provided below Table 4]; table may not "foot" due to rounding to the nearest percentage)

Using Table 5 above as a reference, I have classified all of PSEC's debt investments into the appropriate classifications (floating-rate, structured securitizations, fixed-rate/non-accrual) as of 6/30/2016. I have further classified all of PSEC's floating-rate debt investments into the applicable cash LIBOR floors (separating the company's "collateralized loan obligation" ("CLO") investments for additional accuracy). All of PSEC's equity investments are excluded from Table 5 due to the fact this topic/trend does not apply to that type of investment. By looking at the data within Table 5 above, one can better understand how a rise in current/spot LIBOR would impact PSEC's interest income that would be generated on the company's floating-rate debt investments.

It should also be noted each specific debt investment, including at times several debt investments within one portfolio company, have different underlying term sheets which dictates which LIBOR tenor/maturity is attached to that investment. While most debt investments are usually associated with 1- or 3-month tenors/maturities, there are some instances where the 6- and 12-month tenors/maturities are used for an investment's cash LIBOR floor instead. In addition, some borrowers have the option to use the LIBOR tenor/maturity of their choosing. As such, in the current interest rate environment, it would be to the borrower's best option to choose the 1-month tenor/maturity regarding cash LIBOR floors (lowest rate). A specific breakout of which of PSEC's debt investments are tied to which LIBOR tenors/maturities is beyond a "free to the public" article (however, I will answer general inquiry questions).

As of 6/30/2016, 35% of PSEC's debt investments had cash LIBOR floors of less than or equal to 1.00%. This means when the corresponding current/spot LIBOR percentage rises above 1.00%, 35% of PSEC's debt investments would begin to recognize additional interest income. This specific classification increased 1% when compared to the prior quarter. However, when compared to most sector peers, this was still a fairly low percentage of debt investments having cash LIBOR floors at or below 1.00%. With that being said, this negative trend is countered by the fact 88% (rounded) of PSEC's debt investments had floating interest rates as of 6/30/2016 (when based on FMV). In comparison, only 51% and 62% of Apollo Investment Corp.'s (NASDAQ:AINV) and Main Street Capital Corp.'s (NYSE:MAIN) debt investments had floating interest rates as of 6/30/2016, respectively. Both AINV and MAIN would see less of a benefit when compared to most BDC peers (including PSEC).

As of 6/30/2016, 9%, 2%, and 2% of PSEC's debt investments had cash LIBOR floors of 1.25%, 1.50%, and 1.75%, respectively. Therefore, 48% of PSEC's debt investments had cash LIBOR floors less than 2%. This percentage was unchanged when compared to 3/31/2016. As of 6/30/2016, 16% of PSEC's debt investments had cash LIBOR floors at or greater than 2.00% while 24% of the company's investment portfolio consisted of structured securitizations. As such, 13% of PSEC's debt investments either had no cash LIBOR floor (fixed-rate investment) or were on non-accrual status.

When analyzing PSEC's cash LIBOR floor over the recent past, when excluding CLO investments, the company had a weighted average of 1.54% as of 12/31/2014. In contrast, PSEC was able to lower the company's weighted average cash LIBOR floor to 1.30% as of 6/30/2016. When calculated, this was a weighted average cash LIBOR floor decrease of (24) basis points ("bps") during the prior six quarters which I believe should be seen as a positive trend. However, out of the eleven BDC stocks I currently cover, PSEC had the highest weighted average cash LIBOR floor as of 6/30/2016 (by 17 bps). A recent weighted average cash LIBOR floor comparison between PSEC and ten other BDC peers was provided in the following article:

Prospect Capital Corp.'s NAV, Dividend, And Valuation Compared To 10 BDC Peers (Post Calendar Q2 2016 Earnings) - Part 2 (Including Dividend Sustainability Probabilities For All Companies)

Eventually, as each cash LIBOR floor is surpassed, PSEC will begin to recognize increased interest income on the company's floating-rate debt investments. This will directly have a positive impact on PSEC's future dividend sustainability. NII would also begin to increase because, as of 6/30/2016, PSEC had 100% of the company's outstanding borrowings in the following fixed-rate liabilities (based on FMV): 1) senior convertible notes of $1.09 billion; 2) senior unsecured notes of $710 million; and 3) Prospect Capital InterNotes of $909 million.

Since PSEC has "locked in" fixed-rate debt financing over an extended period of time, a rise in current/spot LIBOR should be seen as a positive catalyst for the company. I continue to believe the increase in interest income would "trump" the increased risk of non-performance/non-accruals as current/spot LIBOR increases (non-accruals would lower interest income). Again, I state as such because I am projecting an incremental, gradual rise in the Fed Funds Rate/LIBOR. In my opinion, this scenario is actually more beneficial to PSEC in the "long run" because it puts less stress on the underlying portfolio companies regarding rapidly increasing interest payments.

2) FMV Investment Rating Analysis on PSEC's Debt and Equity Investments:

The second topic/trend to discuss is a FMV investment rating analysis on PSEC's debt and equity investments. Since FMV write-downs are one of the main determinants of whether to put a debt investment on non-accrual status (through heightened credit risk; ceasing to recognize interest income on a particular loan), this analysis has a direct impact on PSEC's future dividend sustainability. Furthermore, since FMV write-downs (whether unrealized or realized) directly impact PSEC's EPS in the quarter of occurrence, this analysis also has a direct impact on the company's future NAV sustainability.

I believe this analysis will bring some added clarity to readers to better understand how PSEC's investment portfolio was rated, regarding investment valuations, as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016. To begin this analysis, Table 6 is provided below.

Table 6 - PSEC Investment Rating Analysis as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016 (Based on FMV)

(Source: Table created entirely by myself, partially using PSEC data obtained from the SEC's EDGAR Database [link provided below Table 4])

Using Table 6 above as a reference, I classify PSEC's debt and equity investments within one of the following three portfolios: 1) control (dark blue coloring); 2) affiliate (olive green coloring); or 3) non-control/non-affiliate (purple coloring). A control investment is where PSEC owns (through an equity investment) at or greater than 25% of a portfolio company's outstanding voting securities. An affiliate investment is where PSEC owns (through an equity investment) at or greater than 5% but less than 25% of a portfolio company's outstanding voting securities. Within these three classifications, five different investment ratings are shown based on each portfolio's recent FMV. I am including five separate points in time to better highlight past unrealized appreciation (depreciation) within each classification. In my professional opinion, this specific analysis is a good forward-looking metric to spot potential portfolio companies that would have a higher probability for an eventual loss of principal and/or non-accrual. In addition, spotting certain past/recent trends within a BDC's investment portfolio provides additional insight regarding accurate, reliable projections in the future.

An investment rating of "1" describes the portion of PSEC's debt and equity investments that were performing at or above expectations. An investment rating of "2" describes the portion of investments that were performing near expectations. An investment rating of "3", "4", and "5" describes the portion of investments that were performing slightly, modestly, or materially below expectations, respectively.

Investment Rating 1 and 2 (Performing Near, At, or Above Expectations):

Still using Table 6 as a reference, I have classified 80%, 68%, 57%, 57%, and 63% of PSEC's investment portfolio performing at or above expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively (based on FMV). As such, PSEC's investment portfolio had a notable percentage decrease regarding debt and equity investments performing at or above expectations during the fiscal first and second quarters of 2016. In my opinion, this should be seen as a "cautionary"/negative trend. However, PSEC's investment portfolio experienced a slight improvement during the company's fiscal fourth quarter of 2016. This should be seen as an encouraging sign. As of 6/30/2016, this investment rating had a FMV of $3.72 billion.

I have classified 9%, 18%, 20%, 22%, and 20% of PSEC's investment portfolio performing near expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. As such, PSEC's investment portfolio had a notable percentage increase regarding debt and equity investments performing near expectations during the fiscal first quarter of 2016. This increase was mainly attributable to various debt and equity investments being reclassified from an investment rating of 1 to an investment rating of 2. However, this general trend slightly "reversed course" during PSEC's fiscal fourth quarter of 2016. Some investments classified as an investment rating 2 were moved back up to an investment rating of 1 as stated above (a positive trend). As of 6/30/2016, this investment rating had a FMV of $1.20 billion.

When combined, I have classified 89%, 86%, 77%, 79%, and 83% of PSEC's investment portfolio performing near, at, or above expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. When calculated, these two combined investment ratings had an increase (decrease) of (3%), (9%), 2%, and 4% during the fiscal first, second, third, and fourth quarters of 2016, respectively. I believe a majority of PSEC's investment portfolio continued to be performing near, at, or above expectations. However, it would also appear there was a gradual decrease in the percentage of investments performing near, at, or above expectations during PSEC's fiscal first and second quarters of 2016. With that being said, I believe this deterioration slightly reversed course during PSEC's fiscal third and fourth quarters of 2016 which should be seen as a positive trend. With that being said, the proportion of investments that exhibited varying levels of underperformance/non-performance was still fairly notable.

When calculated, I have determined 11%, 14%, 23%, 21%, and 17% of PSEC's investment portfolio was experiencing varying levels of underperformance/non-performance as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. While these percentages may seem a bit alarming, when compared to the ten other BDC peers I currently cover, PSEC had an average percentage of debt and equity investments performing either slightly, modestly, or materially below expectations as of 6/30/2016.

To put things in better perspective, as was discussed in a prior BDC comparison article, the following "FMV versus cost ratios" were provided for PSEC and ten other BDC peers as of 3/31/2016 (in order of highest to lowest ratio): 1) NEWTEK Business Services Corp. (NASDAQ:NEWT) 1.2790x; 2) MAIN 1.0531x; 3) Golub Capital BDC Inc. (NASDAQ:GBDC) 1.0112x; 4) Solar Capital Ltd. (NASDAQ:SLRC) 0.9965x; 5) Ares Capital Corp. (NASDAQ:ARCC) 0.9910x; 6) PSEC: 0.9683x; 7) Fifth Street Senior Floating Rate Corp. (FSFR) 0.9545x; 8) Fifth Street Finance Corp. (FSC) 0.9395x; 9) Medley Capital Corp. (NYSE:MCC) 0.9138x; 10) Apollo Investment Corp. 0.9098x; and 11) American Capital Senior Floating Ltd. (NASDAQ:ACSF) 0.9012x.

Investment Rating 3 (Performing Slightly Below Expectations):

I have classified 7%, 6%, 7%, 8%, and 6% of PSEC's investment portfolio performing slightly below expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. All debt and equity investments within this classification should be carefully monitored each quarter to watch for future FMV write-downs and possible eventual non-accruals. As of 6/30/2016, this investment rating had a FMV of $362 million. When calculated, this analysis shows PSEC's investment portfolio had a decreased FMV balance of ($92) million regarding the company's debt and equity investments performing slightly below expectations between the end of the fiscal fourth quarter of 2015 and fiscal fourth quarter of 2016.

Investment Rating 4 (Performing Modestly Below Expectations):

I have classified 4%, 5%, 11%, 7%, and 7% of PSEC's investment portfolio performing modestly below expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. All debt investments within this classification should be CONSIDERED for non-accruals. In other words, heightened monitoring should occur. Also, debt and equity investments within this classification have a modest probability of a partial non-recovery of one's remaining principal/cost basis. As of 6/30/2016, this investment rating had a FMV of $394 million. When calculated, this analysis shows PSEC's investment portfolio had an increased FMV balance of $165 million regarding the company's debt and equity investments performing modestly below expectations between the end of the fiscal fourth quarter of 2015 and fiscal fourth quarter of 2016. I believe this should be seen as a negative trend due to the fact a majority of this increase was attributable to several sizable debt and equity investments being reclassified from a higher investment rating (1,2, or 3) to an investment rating of 4. However, it should also be noted there was a modest and minor FMV decrease within this investment rating for the fiscal third and fourth quarters of 2016, respectively. I believe this should be seen as a more recent positive trend.

Investment Rating 5 (Performing Materially Below Expectations):

Finally, I have classified less than 1%, 3%, 5%, 6% and 4% of PSEC's investment portfolio performing materially below expectations as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively. All debt investments within this classification should be on non-accrual status unless there is a specific reason otherwise (which can [and does] occur). Also, certain debt and equity investments within this classification have a modest - high probability of a partial non-recovery of one's remaining principal/cost basis (including a possible total write-off).

As of 6/30/2016, this investment rating had a FMV of $227 million. When calculated, this analysis shows PSEC's investment portfolio had an increased FMV balance of $200 million regarding the company's debt and equity investments performing materially below expectations between the end of the fiscal fourth quarter of 2015 and fiscal fourth quarter of 2016. It is never a positive trend when a company has any part of its investment portfolio within this rating classification. From a FMV perspective, the monetary amount of PSEC's investments with a rating classification of 5 materially increased in the matter of three fiscal quarters. I believe this should be seen as a negative trend due to the fact a majority of this increase was attributable to several sizable debt and equity investments being reclassified from a higher investment rating (1, 2, 3, or 4) to an investment rating of 5.

With that being said, to remain non-bias, it appears market participants, via PSEC's current stock price, have already "priced-in" the probability that most of this investment rating will only have a partial recovery of the company's principal/cost basis. In other words, I believe the market has basically priced-in this rating classification when valuing PSEC. In addition, during PSEC's fiscal fourth quarter of 2016, the investment rating had a FMV decrease of ($133) million. I believe this should be seen as a positive trend.

As of 6/30/2016, the following portfolio companies had at least one debt or equity investment that was materially underperforming expectations (excludes investments with a FMV of $0 or an escrow receivable balance): 1) Arctic Energy Services, LLC (Arctic); 2) CP Energy Services Inc. (CP Energy); 3) Freedom Marine Solutions, LLC (Freedom); 4) Gulf Coast Machine and Supply Co. ("Gulf"); 5) NMMB, Inc. ("NMMB"); 6) USES Corp. ("USES"); 7) Valley Electric Company, Inc. (Valley); 8) Wolf Energy, LLC ("Wolf"); 9) Targus International, LLC (Targus); 10) Ark-La-Tex Wireline Services, LLC (Ark-La-Tex); 11) Pinnacle (US) Acquisition Company Limited (Pinnacle); 12) Spartan Energy Services, Inc. (Spartan); 13) Speedy Group Holdings Corp. (Speedy); 14) Venio LLC (Venio); and 15) several CLO investments. Again, I am not saying the ENTIRE investment in each of these portfolio companies had an investment rating of 5 (where multiple investments exist). However, at least one debt or equity investment within each of the portfolio companies listed above had a rating classification of 5.

The following portfolio companies listed above had debt investments on non-accrual status as of 6/30/2016: 1) Gulf; 2) USES; 3) Wolf; 4) Targus; 5) Ark-La-Tex; 6) Spartan; and 7) Venio. Readers should understand any future non-accruals would bring the risk of a slight decrease in interest income per GAAP and the risk of further decreases in NAV from future FMV write-offs. In addition, it should be noted PSEC completed a couple debt-to-equity exchanges during the company's fiscal first and second quarters of 2016. This typically has a negative impact on NII as the prior accrued interest income does not exist anymore while the probability of an investment generating consistent dividend income meeting its prior interest income is a low probability. This is because PSEC's recent debt-to-equity exchanges were performed on portfolio companies that were experiencing weakening operating performance. As such, these companies would most likely not have underlying E&P. As such, any distributions would not be considered dividend income.

It should also be noted this same analysis in prior quarters previously highlighted to readers several recent troubled portfolio companies and correctly identified the following three non-accruals that occurred during PSEC's fiscal fourth quarter of 2016: 1) USES; 2) Ark-La-Tex; and 3) Spartan. To reiterate, I believe this specific analysis is a great forward-looking metric to spot specific portfolio companies at heightened risk regarding future non-accruals.

This analysis shows 89%, 86%, 77%, 79%, and 83% of PSEC's investment portfolio was relatively stable and in "good health" as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively (performing loans and equity investments; based on FMV). However, 11%, 14%, 23%, 21%, and 17% of PSEC's investment portfolio showed signs of slight, modest, or material underperformance as of 6/30/2015, 9/30/2015, 12/31/2015, 3/31/2016, and 6/30/2016, respectively.

I believe the debt and equity investments within these lower classifications should continue to be monitored to a greater degree as they are the most susceptible to continued FMV write-downs, non-performance (which would lead to non-accruals), and ultimately a probable partial (in some cases total) loss of principal/cost basis. This would negatively impact PSEC's future dividend and NAV sustainability.

3) Quarterly FMV Analysis on PSEC's Portfolio Companies:

The last topic/trend to discuss is a quarterly FMV analysis associated with PSEC's portfolio companies for the past six quarters (3/31/2015 - 6/30/2016). This is somewhat different than the FMV investment ratings analysis performed in the previous section of the article. This quarterly FMV percentage analysis shows specific portfolio companies where noticeable unrealized FMV fluctuations occurred over a greater period of time. This analysis helps detect fluctuations that have recently occurred and identifies potential struggling investments that were once (or still are) performing near, at, or above expectations. This analysis also identifies certain prior troubled investments that are now beginning to show signs of improvement. Spotting these trends will lead to a more accurate portrayal of PSEC's future NAV sustainability. To begin this analysis, Table 7 is provided below.

Table 7 - PSEC Portfolio Company FMV Analysis (Investment Ratings 3/31/2015 - 6/30/2016)

(Source: Table created entirely by myself, including all calculated figures and ratios)

Using Table 7 above as a reference, the following portfolio companies had a notable valuation fluctuation over the prior six quarters (3/31/2015 - 6/30/2016): 1) Arctic; 2) CP Energy; 3) Gulf; 4) R-V Industries, Inc. (R-V); 5) Apidos CLO XV, Ltd. (Apidos XV); 6) Ark-La-Tex; 7) Armor Holding II, LLC (Armor); 8) Atlantis Healthcare Group (Atlantis); 9) Cent 17 CLO Ltd. (Cent 17); 10) Cent 20 CLO Ltd. (Cent 20); 11) Cent 21 CLO Limited (Cent 21); 12) Empire Today, LLC (Empire); 13) Galaxy XVII CLO, Ltd. (Galaxy XVII); 14) HarbourView CLO VII, Ltd. (HarbourView VII); 15) Jefferson Mill CLO Ltd. (Jefferson Mill); 16) Lasership Inc. (Lasership); 17) Nixon, Inc. (Nixon); 18) Octagon Investment Partners XV, Ltd. (Octagon XV); 19) Pacific World Corp. (Pacific World); 20) Pinnacle; 21) Prince Mineral Holding Corp. (Prince); 22) Spartan; 23) Speedy; 24) Sudbury Mill CLO, Ltd. (Sudbury); 25) Symphony CLO IX, Ltd. (Symphony IX); 26) Symphony CLO XIV, Ltd. (Symphony XIV); 27) United Sporting Companies, Inc. (United Sporting); 28) Venio; and 29) Washington Mill CLO Ltd. (Washington Mill).

Some fluctuations, mostly negative over time, pertained to credit risk. This includes several oil and gas portfolio companies such as Arctic, CP Energy, Ark-La-Tex, and Spartan. Other portfolio companies such as Gulf, Pinnacle, Speedy, and Venio have also experienced heightened credit risk. Most of these portfolio companies started out as performing at or above expectations but then began performing slightly, then modestly, and most recently materially below expectations. For these portfolio companies, I believe this should be seen as a negative trend. As of 6/30/2016, Gulf, Ark-La-Tex, Spartan, and Venio were on non-accrual status while Arctic and CP Energy had recent debt-to-equity exchanges (debt investments were either, or would have been put, on non-accrual status). Over the next several quarters, I believe several of PSEC's oil and gas portfolio companies, Pinnacle, and Speedy are at the greatest risk regarding non-performance. In future quarters, these portfolio companies will be the first group of investments I pay attention to regarding quarterly FMV fluctuations. The performance of these portfolio companies will have a direct impact on PSEC's future dividend and NAV sustainability.

With that being said, some of the fluctuations shown in Table 7 were more due to spread/basis risk. As discussed earlier, there was a market sell-off within certain pockets of global/U.S. debt markets (especially lower/unrated corporate/high yield bonds) towards the end of 2015 - the second week of February 2016. As such, lower bids (prices) occurred within these types of investments which directly led to capital depreciation. In other words, LMM/MM/UMM pricing came under notable pressure due to high yield debt market "jitters" that negatively impacted valuations across the entire BDC sector. This included most CLO investments which were impacted by lower pricing (due to heightened volatility/a minor "uptick" in defaults) and the net movement across the forward LIBOR curve.

However, it should also be noted this bearish trend reversed course during the second-half of February 2016-September 2016 as spreads/yields have modestly - materially tightened/decreased. As such, this has caused most LMM/MM/UMM pricing to net increase. This has been a more recent positive sector catalyst as most BDC peers reported a net increase to NAV during the calendar second quarter of 2016. While LMM/MM/UMM pricing did not notably increase during the calendar third quarter of 2016, I am also not anticipating notable decreases in valuations as experienced during late last year/earlier this year. As such, I expect "muted" quarterly net valuation fluctuations within most of PSEC's investment portfolio during the company's fiscal first quarter of 2017 (calendar third quarter of 2016). Of course, each investment needs to be separately monitored/valued but broader market tendencies should also be considered when it comes to valuations (level 3 assets per Accounting Standards Codification ("ASC") 820).

Conclusions Drawn- PART 2:

To summarize what was performed in PART 2, the following three topic/trends were discussed which have a direct impact on PSEC's future dividend and NAV sustainability: 1) an in-depth analysis on how the company's investment portfolio is currently set up for a rise in current/spot LIBOR over the next several years; 2) a FMV investment rating analysis on the company's debt and equity investments over the prior five quarters; and 3) a quarterly FMV analysis on specific portfolio companies over the prior six quarters.

When all the information from both parts of the article (four tests from PART 1 and the three topics/trends from PART 2) are taken into consideration, I believe the probability of PSEC being able to maintain the company's current monthly dividend of $0.0833 per share over the foreseeable future is high (80%).

As such, I am projecting PSEC will declare the following monthly dividends for November 2016-January 2017 when the company reports earnings for the fiscal first quarter of 2017 in early November:

Dividend for November 2016 (Paid in December 2016): $0.0833 per share

Dividend for December 2016 (Paid in January 2017): $0.0833 per share

Dividend for January 2017 (Paid in February 2017): $0.0833 per share

When considering PSEC's dividend over the next several years, I believe investors will need to continue monitoring the relationship between the positive impacts of the eventual continued increase in current/spot LIBOR (which would ultimately increase the company's NII) offset by heightened credit risk which could lead to non-accruals (which would decrease the company's NII).

When the three topics/trends from PART 2 of this article are taken into consideration, including other factors not specifically analyzed in this article, I believe there is relatively strong evidence some of PSEC's debt and equity investments are at heightened risk for varying levels of net realized/unrealized FMV depreciation (especially several oil and gas portfolio companies) over the foreseeable future. However, there are also a few debt and equity investments that should continue to perform above expectations and experience FMV appreciation as high yield debt prices have rebounded from levels seen late last year-earlier this year.

As such, I am projecting the following PSEC quarterly NAV ranges over the next several fiscal quarters:

NAV as of 9/30/2016: $9.40 - $9.90 per share

NAV as of 12/31/2016: $9.35 - $9.95 per share

NAV as of 3/31/2017: $9.30 - $10.00 per share

Therefore, I am currently projecting more muted fluctuations in PSEC's NAV over the next three fiscal quarters when compared to the notable fluctuations that occurred late last year. This considers the recent modest tightening of spreads within the high yield debt market. This is partially offset by an increase in credit risk regarding PSEC's oil and gas investments and several other portfolio companies. With that being said, PSEC should still be able to generate a positive "economic return" (dividends received and change in NAV) over the next three combined fiscal quarters.

My BUY, SELL, or HOLD Recommendation:

In my opinion, the following positive factors/catalysts should be highlighted for existing and potential PSEC shareholders: 1) recent minor-modest price increases within the high yield debt market (positively impacts valuations; more "muted" in the current quarter though); 2) quarterly economic returns being generated in most quarters; 3) eventual separation of CLO, online lending, and real estate investments through spin-offs; 4) continued attractive cumulative UTI balance; 5) continued strong cumulative performance regarding several control investments; 6) continued "modest" exposure to the oil and gas sector when compared to sector peers; 7) continued high percentage of floating-rate debt investments; and 8) notable insider purchases of common stock by the company's Chief Executive Officer ("CEO") John Barry (since 12/9/2015 has purchased 14.7 million outstanding shares of common stock [excludes all reinvestments] for a total purchase price of $98.0 million).

However, the following cautionary/negative factors should cause heightened awareness for existing and potential PSEC shareholders: 1) continued suppressed dividend and structuring/fee income (excluding the recent one-time fees associated with the Harbortouch sale); 2) recent low loan originations when compared to historical averages (past quarter was still below historical averages; negatively impacts NII); 3) continued modest-material depreciation within several control/non-control investments (including most oil and gas portfolio companies) and recent notable uptick in non-accruals; 4) "non-amendment" of the company's Investment Advisory Agreement with Prospect Capital Management L.P. (regarding the "2%/20%" fee structure); 5) recent increased default percentage within the company's CLO portfolio (has to be continually monitored going forward); 6) continued delays regarding the company's three proposed spin-offs (first spin-off is now "pushed back" to the calendar fourth quarter of 2016 at the earliest); 7) high weighted average cash LIBOR floor and cost of funds rate when compared to sector peers; and 8) lack of share repurchases initiated by PSEC (the company itself; not insider purchases which do not impact the amount of dividend distributions accrued for/paid).

PSEC recently closed at $7.96 per share as of 10/14/2016. This was a ($1.69) per share discount to the mean of my projected PSEC NAV as of 9/30/2016 range ($9.65 per share). This calculates to a price to NAV ratio of 0.8249 or a discount of (17.51%).

When combining the analysis above with various other factors/analytical metrics not discussed within this specific article (some factors were covered in PART 1), I currently rate PSEC as a SELL when the company's stock price is trading at less than an (17%) discount to the mean of my projected NAV as of 9/30/2016 range, a HOLD when trading at or greater than an (17%) but less than a (24%) discount to the mean of my projected NAV as of 9/30/2016 range, and a BUY when trading at or greater than a (24%) discount to the mean of my projected NAV as of 9/30/2016 range. These percentage ranges are unchanged when compared to my last PSEC article (approximately three weeks ago).

As such, I currently rate PSEC as a HOLD (however, close to my SELL range). My current price target for PSEC is approximately $8.00 per share. This is currently the price where my HOLD recommendation would change to a SELL. This price target is unchanged when compared to my last PSEC article. My current re-entry price for PSEC is approximately $7.30 per share. This is currently the price where my HOLD recommendation would change to a BUY. This re-entry price is also unchanged when compared to my last PSEC article.

Final Note: Each investor's BUY, SELL, or HOLD decision is based on one's risk tolerance, time horizon, and dividend income goals. My personal recommendation will not fit each reader's current investing strategy. The factual information provided within this article is intended to help assist readers when it comes to investing strategies/decisions.

Disclosure: I am/we are long FSFR, NEWT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I currently have no position in PSEC, ACSF, AINV, ARCC, FSC, GBDC, MAIN, MCC, or SLRC.