Updated on October 1st, 2024 by Felix Martinez
Business Development Companies — or BDCs, for short — allow investors to generate income with the potential for robust total returns while minimizing the tax paid at the corporate level.
Despite these advantages, investors generally avoid business development companies. This may be due to the tax implications of their distributions for their shareholders. But even with the added headache come tax time, BDCs can still be worthwhile for income investors.
Prospect Capital Corporation (PSEC) is one of the more attractive business development companies in the market today.
Prospect stands out from the crowd in that it pays monthly dividends, giving its shareholders a steady and predictable passive income stream, which is highly appealing to income investors.
There are currently just 78 monthly dividend stocks. You can download our full Excel spreadsheet of all monthly dividend stocks (along with metrics that matter, like dividend yield and payout ratio) by clicking on the link below:
Prospect Capital’s dividend yield is 13.5%, more than six times that of the average S&P 500 Index. Our full list of stocks with 5%+ dividend yields is here.
Prospect’s high dividend yield and monthly dividend payments are two of the reasons why the company merits further research. This article will discuss the investment prospects of Prospect Capital Corporation in detail.
Business Overview
Prospect Capital Corporation is a Business Development Company founded in 2004. It is one of the largest, with a market cap of almost $2.3 billion.
Details about Prospect Capital’s business model can be seen below.
Source: Investor Presentation
Prospect Capital is a leading provider of private equity and private debt financing for middle-market companies, broadly defined as a company with between 100 and 2,000 employees.
Prospect Capital benefits from operating in the middle market because it lacks competition from larger, more established lenders.
Middle-market companies are generally too small to be customers of commercial banks but too large to be served by the small business representatives of retail banks. Prospect Capital does business in the “sweet spot” between these two services. This lack of competition in this sector has allowed Prospect Capital to finance some truly attractive deals.
Investors should note that Prospect Capital is highly exposed to volatile interest rates. This is because the company’s liabilities are nearly all at fixed rates, while its investments are nearly all floating-rate instruments. That means interest expense is largely fixed, while interest income rises and falls commensurately with prevailing interest rates.
As interest rates rise, the revenues from Prospects floating-rate interest-bearing assets will increase. At the same time, Prospect’s interest expense will remain constant since most of its debt is fixed. Of course, the opposite is true, as falling rates generally mean declining interest income.
This makes Prospect Capital a great portfolio hedge against interest-sensitive securities like REITs and utilities, but it underperforms when rates are very low and when rates are declining.
Prospect Capital’s flexible origination mix is also a meaningful positive from an investor’s perspective, given that the wide variety of instruments it uses to produce income helps it find the best opportunities.
The company has nine different ways to invest with target companies, including different types of debt and equity. They all have different risk levels and rates of return.
Prospect Capital’s willingness to seek out the best instruments — and having the scale to do so — is a major advantage over other middle-market BDCs. The company’s investment strategy is central to its long-term growth.
Growth Prospects
Prospect Capital’s growth prospects stem largely from the company’s ability to:
Raise new capital via debt or equity offerings
Invest this new capital in deal originations with an internal rate of return higher than the cost of capital raised in Step 1
Prospect’s ability to source new deals that offer appropriate risk-adjusted returns is the most important part of this process.
Fortunately for the company (and its investors), there is no shortage of new deals for Prospect’s consideration. The company has thousands of deal opportunities each year, allowing it to be very selective in its investment decision-making.
Prospect reported its fourth-quarter and full-year earnings on August 28, 2024, showing somewhat weak results. Net interest income per share, similar to net earnings, was $0.25, down from $0.28 a year earlier but exceeding the expected $0.18. Total investment income, Prospect’s equivalent of revenue, decreased year-over-year from $221.5 million to $212.3 million.
Quarter-over-quarter, total originations increased from $220 million to $242 million, while repayments and sales more than doubled, reaching $245 million. As of fiscal Q1, originations were $161 million, while repayments were $253 million, indicating a portfolio shrinkage of about $90 million.
The annualized current yield remained at 12.1%, unchanged from Q3 but lower than 13.2% a year earlier. Total investments at fair value were $7.72 billion, down slightly from $7.81 billion in March but stable year-over-year. For 2025, adjusted net interest income per share is projected to be $0.61, though results are expected to remain volatile due to fluctuating interest rates.
This is the result of higher prevailing interest rates. We continue to see 93 cents in net investment income for this year, but note that 2024 may represent the top for the medium term, given favorable interest rate conditions.
Source: Investor Presentation
Dividend Analysis
Prospect Capital’s dividend is the obvious reason investors would choose to own the stock, so it is critical that the dividend is as safe as possible. As a BDC, Prospect Capital has no choice but to distribute essentially all of its taxable income to shareholders. Because of this, its payout ratio will always be very high and sometimes variable.
In other words, the dividend is actually covered by net investment income and has been for some time, meaning the payout should be relatively safe, barring a sizable impact from any potential economic downturn.
The company has declared $21.12 in cumulative distributions to shareholders since 2004. That’s almost three times the current share price.
Source: Investor Presentation
Clearly, the draw for Prospect Capital is in its ability to generate cash to return to shareholders, and over time, it has done that well.
The dividend appears safe for now, but investors should continuously monitor the company’s net investment income for any signs of trouble that could potentially lead to further cuts down the road. We don’t see that as a threat at the moment, as the company has consistently covered its payout in the past several quarters.
Related: 3 Reasons Why Companies Cut Their Dividends (With Examples)
Final Thoughts
Prospect Capital’s high 13.5% dividend yield and monthly distributions are two of the main reasons an investor might take an interest in this stock.
Taking a closer look reveals that this BDC has a high-caliber leadership team and has positioned itself to thrive in most environments.
The dividend appears sustainable for the time being, meaning Prospect is worth a look for those investors seeking high levels of current income and monthly payments, plus stomach the inherent risks of owning a BDC.
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