Summary
- Prospect Capital covered its dividend with net investment income in the last quarter.
- Investors should not be seduced by the 23% discount on net asset value.
- In the next recession, Prospect Capital might again have to cut its dividend.
Prospect Capital Corporation ( PSEC ) managed to cover its dividend payment with net investment income in the most recent quarter, but the company's net asset value fell yet again.
Prospect Capital has a poor track record of increasing its net asset value, and the company has also been a serial dividend cutter. This means that, despite the fact that Prospect Capital is available at a discount valuation, passive income investors cannot be confident in Prospect Capital's monthly dividend.
Aggressively-Positioned Investment Portfolio
Prospect Capital is a business development firm focused on the middle market that makes investments across the capital structure. However, when compared to other business development companies that are much more defensively positioned, the First Lien percentage is relatively low at 53%.
Prospect Capital's aggressive portfolio structure includes a significant net asset allocation to risky investments such as equity (19.3% of the portfolio) and subordinated notes (9.0% of the portfolio).
Ares Capital Corporation ( ARCC ) and Golub Capital Corporation ( GBDC ) have significantly higher proportions of their net assets invested in more secure First Liens.
Prospect Capital's more aggressive portfolio structure has significant implications for passive income investors who are willing to accept more risk in exchange for a potentially higher return on investment.
However, if there is a significant economic downturn and non-accruals in Prospect Capital's portfolio rise, the BDC's offensive portfolio structure could become a problem.
Prospect Capital Saw An Uptick In Non-Accruals
Prospect Capital's portfolio quality has suffered a minor decline since its non-accrual ratio increased from 0.3% in the September quarter to 0.5% in the December quarter.
The non-accrual ratio has not yet reached a concerning level, but to be honest, Prospect Capital has not had the best track record in terms of increasing net asset value, net investment income, and dividends, so I am much more concerned about Prospect Capital's non-accrual ratio than I am with other BDCs. In the case of Prospect Capital, a non-accrual ratio greater than 1.0% would be problematic for me.
Prospect Capital's Dividend Is Covered By NII (For Now)
Prospect Capital reported net investment income of $0.23 per share in the December quarter, outperforming the total quarterly dividend payout of $0.18 per share.
Prospect Capital currently pays a monthly dividend of $0.06 per share, for a total dividend payout of $0.72 per share per year. The pay-out ratio in the most recent quarter was 78%, and the dividend pay-out ratio in the previous year was 84%.
Having said that, Prospect Capital has had periods of good dividend coverage, but the BDC has been forced to cut its dividend multiple times over the years.
In my opinion, the risk of a dividend cut is thus exponentially higher than with better-managed business development companies like Ares Capital.
Prospect Capital Trades At A 23% Discount To Net Asset Value
Prospect Capital's net asset value declined from $10.01 per share in the September quarter to $9.94 per share in the December quarter. The BDC's net asset value has fallen 6.2% in the last year.
Prospect Capital's stock is trading at a 23% discount to net asset value due to the BDC's long history of declining net asset value.
I would recommend that passive income investors purchase higher quality BDCs such as Ares Capital or Oaktree Specialty Lending Corporation ( OCSL ) if they want a stable dividend yield without the elevated risk associated with an aggressively positioned investment portfolio. These BDCs have a higher net asset value multiple, but investors will have a much easier and less stressful time owning them.
Why Prospect Capital Could See A Lower/Higher Valuation
Prospect Capital trades at a 23% discount to net asset value, which is high in comparison to other business development firms. However, other BDCs have higher real and perceived portfolio quality, as well as a stronger net asset value/dividend growth history than PSEC.
Another dividend cut and deteriorating portfolio quality are two potential headwinds for Prospect Capital that could result in an even larger net asset value discount in the event of a recession.
My Conclusion
Prospect Capital was able to cover its dividend with net investment income in the quarter ending 31 December 2022, and the dividend pay-out ratio is low enough for investors to have some confidence in the BDC's short-term pay-out capabilities.
Prospect Capital's long-term dividend record, on the other hand, is less than encouraging, as the business development company has cut its payout more than once when its net investment income was no longer sufficient to cover the dividend.
I don't believe PSEC will have to cut its dividend in the near term, but given the aggressive portfolio structure and Prospect Capital's history as a serial dividend cutter, I have little faith that the company will not have to cut its dividend during the next recession. Passive income investors should avoid it.
For further details see:
Prospect Capital: This 9.4% Yield Is A Potential Value Trap