Updated on May 28th, 2021 by Bob Ciura
Business Development Companies – or BDCs, for short – allow investors to generate income with the potential for robust total returns, while minimizing the amount of tax that is paid at the corporate level.
Despite these advantages, business development companies are generally avoided by investors. 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 actually pays monthly dividends, giving its shareholders a steady and predictable passive income stream which is highly appealing for income investors.
There are currently just 54 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 has a tremendously high dividend yield of 8.5%, which is about six times that of the average S&P 500 stock. You can see our full list of stocks with 5%+ dividend yields 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.
Prospect Capital Corporation is a Business Development Company that was founded in 2004. Prospect Capital is one of the largest business development companies and currently has over $6 billion of assets under management.
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.
Operating in the middle market is beneficial for Prospect Capital because of the lack of competition from larger, more established lenders.
Middle-market companies are generally too small to be the customers of commercial banks, but too large to be served by the small business representatives of retail banks. The ‘sweet spot’ between these two services is where Prospect Capital does business. This lack of competition in this sector has allowed Prospect Capital to finance some truly attractive deals.
The company’s current portfolio yield is 9.4%, which is down from 12%+ in recent years. Lower rates across the globe have driven down yields in a variety of asset classes, so this is to be expected.
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 essentially constant since most of its debt is fixed rate. 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 in periods where rates are very low.
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 make investments 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.
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
The most important part of this process is Prospect’s ability to source new deals that offer appropriate risk-adjusted returns.
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, which allows them to be very selective in their investment decision-making.
Prospect reported third-quarter earnings on May 10th, 2021, with results coming in better than expected on both the top and bottom lines. Net investment income came to $0.19 per share, while expectations called for $0.17 per share. This was flat from the year-ago quarter.
Net asset value ended the March quarter at $9.38, up from $8.96 in the December quarter. Interest as a percentage of total investment income was 87.5% in Q3, down from 89.8% in the year–ago period. Total investment income was $160 million, up from $155 million in the year–ago period. The company has also completed $67 million in originations in the June quarter to date, with repayments of $85 million.
The company focuses on disciplined underwriting so as not to take undue risk when making new deals. In addition, it is willing to pass when that is the prudent course of action, as well as exit when the time is right.
Prospect Capital’s dividend is the obvious reason why 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.
For the quarter ended March 31st, Prospect Capital produced $0.19 per share in net investment income, which sufficiently covered its quarterly distribution of $0.18 per share.
In other words, the dividend is actually covered by net investment income at this point, meaning the payout should be relatively safe, barring a sizable impact from the current economic downturn.
The company has now declared more than $18.80 in cumulative distributions to shareholders.
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.
Prospect Capital’s high 8.5% dividend yield and its monthly distributions are two of the main reasons why 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, although historically low interest rates are certainly a negative, at least for the short-term.
The dividend appears sustainable for the time being, meaning Prospect is worth a look for those investors seeking high levels of current income that can stomach the various risks of owning a BDC.