Prospect Capital: Potentially Impacted By Interest Rate Cuts (Rating Downgrade)

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PSEC offers a monthly dividend distribution of $0.06/share that has not grown since 2017.There are better alternative BDCs out there offering superior portfolio investments that have better ...

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Rate cuts are anticipated in the latter half of 2024 and can result in lower profitability metrics.   Olivier Le Moal Overview I previously covered Prospect Capital (NASDAQ:PSEC) back in November of 2023. Since then, PSEC has delivered a total return of nearly 12%. At the time, my original thesis was that the price dropped so significantly that the discount to NAV was about 45%. Such a large discount to NAV presented an opportunity to capture some income while we waited for the price to recover. At the time my original thesis was published, the price of PSEC was $5.14/share. Shortly after the price shot up above $6/share. Now the price has come back down and I think the discount is less attractive this time around. While the premium still sits at a discount to NAV of -38%, I believe the upcoming interest rate changes may negatively impact PSEC's portfolio. PSEC also failed to capture the recent rally in several other BDCs (business development companies). We can see how PSEC has the worst price performance out of the below group of peers. I think that this underperformance is likely to continue because of the portfolio construction and decreasing total investment income. Data by YCharts Financials - Interest Rates PSEC reported their Q2 earnings in February and the results were mixed. NII (net investment income) was reported at $0.24 per share. However, total investment income was $210.94M which fell below last year's performance of $212M. In addition, PSEC has a 5.4x middle market portfolio net leverage ratio across their investments. A ratio of 5.4x means that for every dollar of equity invested, PSEC has borrowed $5.40 to invest in middle-market assets. During the most recent earnings call we also received some confirmation on new originations totaling $171M. Originations in the December quarter aggregated $171 million. We also received $131 million of repayments, sales and exits as a validation of our capital preservation objective, resulting in net originations of over $40 million. As we continue to take a cautious approach towards new credit underwriting given macroeconomic conditions. - Grier Eliasek, President & Chief Operating Officer  Using this sort of leverage can potentially increase returns when investments perform well but also increases the risk of losses if investments underperform. When investments underperform this means that PSEC has higher debt obligations to service and can put strain on their NII. I also believe that future interest rate cuts may threaten the profitability of PSEC. We can sort of see the inverse relationship in price. As rates rise, the price fell and as rates come down, the price increased. While this might be good from a price return perspective, price returns aren't why investors value a monthly paying BDC. They value these investment vehicles for the income they can provide and interest rate cuts may threaten profitability. Data by YCharts With interest rate cuts anticipated on the horizon, we may see NII shrink a bit. As interest rates decrease so do the interest payments on their debt investments. This directly affects PSEC's interest income which in turn has the potential to result in a lower NII and total revenue. In addition, the fair value of PSEC's floating rate debt investments may decline, resulting in unrealized losses on their portfolio and affecting their net asset value and shareholder returns. We can see how total investment income grew as rates were increased over the last two year period.   PSEC Q2 Form 10-Q Portfolio PSEC currently has approximately $7.8B in total assets. They operate within four main segments:  Middle Market Lending: 54% of portfolio Middle Market Buyouts: 18% Subordinated Structure Notes: 8% Real Estate: 18%    PSEC Investor Presentation PSEC's portfolio is very diverse, having exposure across 36 different industries but the primary focus seems to be within real estate, health care providers & services, and consumer finance. The real estate aspect does make this BDC quite different from a lot of the other peers since having such a large percentage in real estate is unusual in this space. Thankfully the majority of the portfolio is contained as senior secured debt which helps provide a sense of security and mitigates risk. Approximately 74% of their portfolio is comprised of first lien senior secured debt and this is important because senior secured debt has the first priority claim when a company defaults or goes through liquidation. On the other end of the spectrum, 17.8% of their portfolio investments are classified as equity which is considered the riskiest. The average weighted yield on their investments sit at 10.1% and the majority of their total income is channeled through recurring interest payments from their portfolio companies. In fact, over 90% of their total revenue comes from recurring interest payments and this is why I believe this presents a vulnerability to future interest rate changes. When rates are lowered, they will likely receive less in interest payments. Dividend & Valuation The latest declared monthly dividend is $0.06 per share and the current dividend yield sits slightly above 13%. NII was reported at $0.24 per share which covers the quarterly distribution total of $0.18 per share. This means that the dividend is covered by nearly 133%. This makes the 80th consecutive dividend declared by PSEC. This BDC remains popular for investors that are looking for monthly income. The monthly distributions can help fund your lifestyle during retirement and provide more flexibility with spending. Prospect Capital has a slightly larger yield than some of its peers but I think that there are better alternatives out there within the BDC space. For example, Capital Southwest (CSWC) has an excellent dividend coverage that is likely to still provide coverage even with interest rate cuts of -50bps. Since CSWC's portfolio is of higher quality, I believe they are a better choice to navigate the impact of future interest rate cuts. You can read more about my thoughts on CSWC here. In addition, PSEC may have one of the larger yields within the BDC space but they've lacked the same kind of growth that some peers have delivered. PSEC's dividend has actually remained mostly flat over the last 5 years while other BDCs have capitalized on higher interest rates with increased dividends or an abundance of supplemental dividends issued to shareholders. Data by YCharts Over the last decade, PSEC has almost never traded at a premium to NAV. In fact, over the last 3 year period the price has traded at an average discount to NAV of 26.23%. PSEC's discount to NAV fell as low as -50% back in the pandemic market drop of 2020. The price currently trades at a discount to NAV of about 38%. For reference, quality and well-performing BDCs have frequently traded at a premium to NAV.   CEF Data For example, here are the current valuation metrics for peer BDCs.  Capital Southwest (CSWC): Trades at a premium to NAV of 44%. Ares Capital (ARCC): Trades at a premium to NAV of 5%. Gladstone Investment Corp (GAIN): a monthly paying BDC that trades at a slight premium to NAV of 6.3%.  These BDCs could trade at premiums to NAV for a multitude of reasons but some examples are a better dividend record, better management, more impressive NII growth, and a higher quality investment portfolio. Coincidentally, these same BDCs outperform PSEC in total return when we include the distributions. Data by YCharts So while I believe there are better alternatives out there within the BDC space, the high yield continues to be enticing for those who value monthly income distributions. Although the dividend is covered by approximately 133% as of the last earnings report, this margin of safety may potentially decrease when interest rates start to get cut. Risk Profile In addition to the underperformance, PSEC also has some segments of vulnerabilities in my opinion. In terms of risk, PSEC has senior unsecured debt maturities upcoming in 2026. The bulk of their debt is senior secured totaling $1,954M with a maturity date in 2027.   PSEC Investor Presentation In addition, PSEC has a large weight of its portfolio in the real estate sector. This leaves the BDC more vulnerable to poor economic cycles than some other BDCs that do not have exposure to the real estate sector. Real estate as a whole has seen numerous rent increases and price increases since the pandemic. Yet, PSEC has failed to capitalize on this with a substantially higher level of NII or price growth. Lastly, interest rate cuts have the ability to lower NII levels. The company has failed to provide impactful dividend raises or supplementals during times of higher interest and investment income. This leaves me to believe that during times of shrinking NII, there is a chance the dividend coverage margin will not be as large as it currently sits. The dividend was cut down from $0.0833 per share in 2017 and I see the possibility of another cut happening if the dividend coverage begins to shrink. Takeaway Prospect Capital remains a popular monthly paying business development company despite its lackluster performance. Since 2017, the poor price movement was able to be mitigated by the continued dividend payments, PSEC still served as a choice for investors who prioritized income. However, with upcoming interest rate cuts on the horizon, there is a chance that the total NII (net investment income) shrinks and threatens the healthiness of the dividend.  There are higher quality alternatives out there within the BDC space that have better capitalized on the higher rate environment by rewarding shareholders with dividend raises and supplemental distributions, whereas PSEC has done neither of those. For example, Gladstone Investment Corp is a great alternative monthly paying BDC that rewarded shareholders with a large supplemental distribution as their NII grew.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.0","shortVersion":"4.24.0","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2422913398"}