Published by Nicholas McCullum on May 20
Business Development Companies – or BDCs, for short – allow investors to generate strong current income and 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 is likely due to the tax implications of their distributions for their shareholders.
More specifically, the dividends of business development companies are composed of returns of capital, qualified dividends, non-qualified dividends, and capital gains. Despite this added headache come tax time, BDCs can still be worthwhile for income investors.
Prospect Capital Corp. (PSEC, Financial) is one of the more attractive business development companies right now. The BDC has a strong track record of delivering total returns to shareholders, and currently has an eye-popping dividend yield of 12.2%. This makes Prospect one of a select group of companies with 5% or higher dividend yields.
Better yet, Prospect actually pays monthly dividends, giving its shareholders a steady, predictable passive income stream ideal for retirees and other income-oriented investors.
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 Corp. in detail.
Business overview
Prospect Capital Corp. is a business development company that was founded in 2004. Prospect Capital is one of the largest business development companies and currently has approximately $7 billion of assets under management.
Details about Prospect Capital’s business model can be seen below.
Source: Prospect Capital Corporation Investor Presentation, slide 2
Prospect Capital’s corporate profile is very similar to Main Street Capital Corp. (MAIN), another business development company that was recently analyzed on Sure Dividend.
Prospect Capital is a leading provider of private equity and private debt financing for middle market companies. A middle market company is broadly defined as a company with between 100 and 2,000 employees. There is not a widely followed revenue band that is used to define a middle market company.
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 12.3% and has seen levels exceeding 13% in recent quarters.
More details about Prospect Capital’s current portfolio holdings can be seen below.
Source: Prospect Capital Corporation Investor Presentation, slide 8
Investors should note that Prospect Capital is well-poised to benefit from rising interest rates.
This is because the company’s liabilities (debt that Prospect owes to lenders) is 99.9% fixed rate, while its interest-bearing assets (debt that other companies owe to Prospect) is 90.7% floating-rate.
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 (99.9%) of its debt is fixed rate.
This makes Prospect Capital a great portfolio hedge against interest-sensitive securities like REITs and utilities in our current rising interest rate environment.
Prospect Capital also benefits from having an exceptionally diversified investment portfolio.
The company’s largest representative sector is structured finance, composing 17.8% of the overall investment portfolio.
All together, Prospect Capital currently has holdings in 36 unique industries. The company’s impressive diversification can be seen below.
Source: Prospect Capital Corporation Investor Presentation, slide 9
Moving on, the next section will discuss the growth prospects of Prospect Capital in detail.
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 .
The most important part of this process is Prospect’s ability to source new deals.
Fortunately for the company (and its investors), there is no shortage of new deals for Prospect’s consideration. The company has more than 3,000 deal opportunities annually, which allows it to be selective in their investment decision-making.
Less than 5% of initially screened investments receive a final investment from Prospect Capital.
More details about the company’s deal flow process can be seen below.
Source: Prospect Capital Corporation Investor Presentation, slide 6
Prospect’s robust deal origination will be the driver of the company’s future growth.
Competitive advantage and recession performance
As a business development corporation that focuses on private debt and equity, Prospect Capital’s main competitive advantage comes from its talent base. Prospect currently has more than 100 investment professionals and is one of the largest private debt/equity players that focuses specifically on middle market companies.
Prospect currently has more than 100 investment professionals and is one of the largest private debt/equity players that focuses specifically on middle market companies.
The company’s leadership has extensive experience in this arena. Prospect's co-founders continue to serve as the company’s CEO and COO, respectively, and the CFO has been with the company for nearly 10 years (since 2008).
Source: Prospect Capital Corporation Investor Presentation, slide 4
Accordingly, Prospect Capital has a competitive advantage that stems from the talent it employs. The company also benefits from its scale-based competitive advantage.
Prospect is one of the largest publicly-traded business development companies and is the leader in the middle market financing segment.
This allows Prospect Capital to source large deals with more creditworthy counterparties, boosting returns while simultaneously reducing risk.
Source: Prospect Capital Corporation Investor Presentation, slide 3
Despite the company’s strong competitive advantages, it should not be viewed as a defensive portfolio holding. Prospect Capital Corporation certainly has much more risk than, say, a blue-chip Dividend Aristocrat like Johnson & Johnson (JNJ).
The great recession of 2007-2009 saw Prospect’s stock decline from a high of around $18 to a recession bottom of $6.58, although the company continued to increase its dividend payments during this time.
Prospect’s security did not perform well during the last recession, but investors should not be too worried that this company will go out of business due to adverse economic conditions.
As a business development company, Prospect is subject to regulations around how much leverage it can use. Prospect is even more conservative than these regulations mandate and has an internal net leverage target of 0.7x-0.8x (the cap from regulators is 1x).
Source: Prospect Capital Corporation Investor Presentation, slide 14
To sum up, Prospect’s stock will not perform well during periods of economic downturns, although the business will likely endure through all but the worse recessions.
Valuation and expected total returns
Total returns for Prospect Capital Corp.’s shareholders will be composed of the stock’s current dividend yield, valuation changes and changes in the company’s net asset value.
Prospect Capital currently pays a monthly dividend of 8.333 cents per share, which yields 12.2% on the company’s current share price of $8.17. It is highly likely that the majority of Prospect Capital’s future shareholder returns will be largely driven by its current dividend yield.
Fortunately, though, the BDC has a healthy habit of increasing its payout to shareholder over time. Since Prospect’s initial public offering in 2004, it has delivered cumulative distributions of $15.96 per share – almost twice the company’s current stock price of $8.17.
Prospect Capital’s long-term dividend history can be seen below.
Source: Prospect Capital Corporation Investor Presentation, slide 15
As a business development corporation, Prospect Capital’s valuation cannot be meaningfully assessed using traditional metrics like the price-earnings ratio.
Instead, we generally look at two main metrics to measure the valuation of a business development company: dividend yield and price-book value.
Prospect’s yield can be used to assess the BDC’s valuation by comparing its current dividend yield to its historical dividend yield. If its current yield is higher, Prospect is undervalued; conversely, if its historical yield is higher, the BDC is overvalued.
Prospect’s current dividend yield is compared to its long-term historical dividend yield in the following diagram.
Source: YCharts
If you’re having trouble finding the gray line in the diagram above, it is because it is hidden behind the green line – Prospect Capital’s current dividend yield is almost exactly equal to its long-term historical average. This indicates that the stock is trading somewhere around fair value.
Prospect Capital’s price-book value can be used as a valuation tool in the same manner.
To calculate Prospect’s current P/B, we first need to determine the company’s net asset value per share at the end of its most recent quarter.
In Prospect’s March quarterly earnings release, the company reported net asset value of $9.43. Some quick math along with the company’s current share price of $8.17 tells us that the stock is trading at a price-book value of 0.87.
Prospect Capital’s current price-book value is compared to its long-term historical average in the following diagram.
Source: YCharts
Unlike when using dividend yield, Prospect Capital appears slightly undervalued when we look at its price-book ratio.
Taking both metrics into account, and we conclude that Prospect Capital is likely trading at or just below fair value. Right now presents a historically good opportunity to initiate or add to a position in this company.
Aside from dividend yield and valuation changes, the remainder of the company’s returns will be composed of changes to its net asset value.
Surprisingly, Prospect’s net asset value has been decreasing over time. The company reported per-share net asset value of $10.24 back in 2010, which means that the company’s net asset value has decreased by about 1% per year (on average) since then. I expect a similar rate of change for Prospect Capital’s net asset value moving forward.
Prospect’s declining net asset value is likely due to the company’s extremely high distribution. Accordingly, this stock is more suited for income investors rather than investors looking to generate total returns.
To sum up, the total returns of Prospect Capital’s stock will be composed of:
- 12.2% dividend yield, partially offset by
- Roughly 1% annual decline in net asset values.
Despite net asset value declines, Prospect Capital shareholders will have a very good probability of realizing double-digit total returns thanks to the company’s exceptionally high distribution yield.
Tax implications
As mentioned in the introduction of this article, BDCs are often avoided by investors because of uncertainties regarding the tax implications of their distributions.
To qualify as a business development company, Prospect Capital must (among other things) satisfy the following criteria:
- Distribute 90% or more of their income as dividends to shareholders.
- Hold 70% or more of their portfolio in "eligible assets," which predominantly includes privately issued debt and equity securities.
- Derive 90% or more of their income from securities: dividends, capital gains and interest income.
The advantage of operating as a business development company is that BDCs typically pay little or no tax at the corporate level.
Instead, BDC investors are taxed individually based on the type of income that the BDC generated in the previous taxation year. Depending on the nature of the business development company, distributions will be composed of capital gains, return of capital (which reduces the investor’s cost basis), qualified dividends and non-qualified dividends.
BDCs inform their investors of the nature of their distributions for tax purposes through an annual information document called a Form 1099.
For investors considering an investment in a business development company like Prospect Capital, it can be useful to look at historical Form 1099s to see how the company’s previous distributions were taxed.
Prospect Capital does not share its form 1099 on their website, but it includes a table that has the same information. It can be seen below.
Source: Prospect Capital Investor Relations
It appears that the majority of Prospect Capital’s distributions are reported as non-qualified dividends. Accordingly, this security is best held in a tax-advantaged account.
Final thoughts
Prospect Capital’s eye-popping 12% 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 business development company has a high-caliber leadership team and has positioned itself to thrive in a rising interest rate environment. Despite the company’s declining net asset value per share, the stock’s high dividend yield makes it a suitable investment for retirees and other investors seeking to generate current income.
Disclosure: I am not long any of the stocks menitoned in this article.
