DBRS Morningstar Assigns LT Ratings of BBB (low) to Prospect Capital Corporation, Trend Stable

DBRS, Inc. (DBRS Morningstar) assigned a Long-Term Issuer Rating of BBB (low) to Prospect Capital Corporation (PSEC or the Company). At the same time, DBRS Morningstar assigned a Long-Term Senior Debt Rating of BBB (low). The trend on the ratings is Stable. The Company’s Intrinsic Assessment (IA) is BBB (low), while its Support Assessment is SA3 resulting in the final rating being positioned in line with the IA.

KEY RATING CONSIDERATIONS
The ratings reflect PSEC’s good franchise which is supported by a sound management team and established market presence over more than 20 years of operation. This franchise has been a key pillar to the Company’s solid earnings track record and ability to develop a diverse funding profile. The ratings also consider the Company’s appropriately managed capitalization. Lastly, the ratings contemplate PSEC’s portfolio riskiness, given that a sizeable portion is comprised of subordinated investments, as well as the elevated portfolio concentration in key asset classes such as property REIT, consumer finance and structured investments that collectively accounted for nearly 42% of its investment portfolio at fair value (FV) at December 31, 2020 (YE20).

The Stable trend reflects our expectation that the Company will continue to prudently expand its investment portfolio, while maintaining sound earnings performance and asset quality. Continued access to the various funding sources the Company has developed, while sustaining the leverage ratio within its target range are factored into the trend. Consistent with our moderate economic scenario published March 17th, 2021, expectations are for a strong economic recovery in 2021, buffered by government stimulus and central bank actions that should produce robust origination pipelines for BDCs.

RATING DRIVERS
Over the longer term, if the Company were to reduce its overall risk profile by increasing the portion of its secured first lien loan portfolio and/or limit the concentration in its key asset classes while maintaining its earnings power, the ratings would be upgraded. Conversely, a prolonged weakening in credit fundamentals and/or a meaningful deterioration in the buffer to the debt facility covenants or regulatory requirements would result in a ratings downgrade.

RATING RATIONALE
Founded in 2004, PSEC has a good franchise that is supported by its access to Prospect Capital Management’s (the Investment Adviser) expertise, scale, broad origination platform and multiple investment strategy capabilities. With $5.7 billion in total assets at FV as of December 31, 2020, PSEC is the third largest business development company (BDC) and one of the oldest in the sector. The Company’s scale and longevity has enabled it to develop an extensive deal sourcing network of established relationships with private equity sponsors, syndicators, intermediaries and portfolio companies. Though the Company primarily provides secured debt financing to private middle-market companies, it also invests in various yield oriented, credit-related strategies that enhance its origination flexibility and portfolio diversity, but increases the risk profile of the balance sheet. As of December 31, 2020, PSEC’s debt investment portfolio was comprised of 122 portfolio companies across 39 industries. The Company’s franchise is also supported by its experienced management team that has navigated PSEC through multiple economic and investment cycles.

PSEC has demonstrated a sound track record of earnings generation capacity. The Company has remained profitable on an annual basis since inception, except for the most recent fiscal year ended June 30, 2020 (FY20). The loss was primarily due to unrealized losses from fair value write downs on investments as a result of the market volatility at the early stages of the Coronavirus Disease (COVID-19) pandemic, which were recovered in 1HFY21. Over the past several years, the Company has generated mostly stable net investment yields (net investment income-to-average investments at cost), largely in-line with the DBRS Morningstar BDC peer group average. That said, a notable portion of interest income is derived from equity investments in CLOs, contributing to attractive portfolio yields yet introducing potential volatility in earnings, which we view less favorably. Specifically, PSEC’s interest income from debt investments has comprised an average of approximately 71% of total investment income over the last five fiscal years, while the portion of interest income from structured credit investments was 20%. Further, payment-in-kind (PIK) interest has averaged nearly 4% of total investment income over this period. For 1HFY21, PSEC generated a net increase in net assets (net income) of $473.7 million, up from $6.9 million in 1HFY20, driven by a significant increase in unrealized gains as net investment income remained essentially flat year-over-year.

We consider the Company’s risk profile as elevated due to its focus in the inherently riskier non-first lien investments, as well as a meaningful component of non-sponsored backed middle market companies. At December 31, 2020, PSEC’s first lien debt investments stood at 47.3% of the total investment portfolio at FV, lower than the DBRS Morningstar BDC peer average of approximately 76%. The typically riskier subordinated portion of the Company’s portfolio at FV was comprised of other senior secured debt (mostly second lien) at 21.2%, structured notes at 13.3%, while equity positions accounted for 18.2%. Further, approximately 35% of PSEC’s debt investments are associated with non-sponsored backed companies. Nonetheless, PSEC’s portfolio risk exposure is mitigated by its well-defined risk management processes embedded in assessing investment opportunities, underwriting, monitoring and restructuring capabilities. Additionally, we view favorably PSEC’s utilization of third-party independent evaluation firms for determining the FV of each portfolio company investment on a quarterly basis. Credit performance of the investment portfolio has improved over the past year despite the pandemic. Specifically, the Company’s non-accruals as a percent of total portfolio at cost were 3.5% at December 31, 2020, down from 8.4% at December 31, 2019.

PSEC has a diversified funding profile with access to multiple funding channels and a broad investor base. The Company’s funding is mostly comprised of unsecured debt resulting in low balance sheet encumbrance. Specifically, at December 31, 2020, the unsecured debt outstanding of $1.8 billion was comprised of convertible, institutional and retail notes of which a notable portion was sourced through programmatic issuance. At December 31, 2020, approximately $4.2 billion, or 74%, of the Company’s assets were unencumbered though it is comprised of largely illiquid assets. Meanwhile, PSEC’s secured debt accounting for 13% of debt outstanding is associated with a revolving credit facility with total committed capacity of $1.1 billion that entails commitments from a highly diversified group of 30 financial institutions. PSEC also has a well-laddered debt maturity profile that is appropriately aligned with investment maturities. Debt maturities are staggered with no maturities in 2021, and just 8% of the outstanding debt at December 31, 2020 maturing in 2022, and only 14% in the subsequent two year period. At December 31, 2020, the Company had readily available liquidity of nearly $492 million, including cash on hand and available borrowing capacity based on previously pledged collateral.

PSEC has demonstrated a track record of disciplined balance sheet management, historically maintaining leverage close to its target levels and mostly below the DBRS Morningstar BDC peer average. The Company’s leverage (debt-to-equity) was 0.62x, at December 31, 2020, comfortably below the regulatory limit and below its target leverage of 0.70x-0.85x (PSEC’s target leverage is based on a net debt basis and therefore reported leverage was 0.61x at YE20). In May 2020, PSEC’s shareholders approved the adoption of the higher regulatory leverage limit (debt-to-equity to 2.0x from 1.0x) which enhances the Company’s capital management flexibility. At December 31, 2020, PSEC had an estimated regulatory capital cushion of nearly $2.4 billion, implying that the Company would need to incur a loss equivalent of approximately 42% of total investments at fair value before breaching its regulatory leverage limit, and nearly a 33% write down before its most restrictive credit facility covenant would be breached. Since its inception, the Company has demonstrated a consistent ability to access the capital markets when needed to support growth. Of note, in 2020, the Company launched a programmatic perpetual convertible preferred stock issuance which over time not only diversifies its funding mix but also provides it the optionality to boost its capital base by converting it to common equity. However, we note that the convertible preferred stock is considered debt for the Company’s regulatory leverage requirements.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at: https://www.dbrsmorningstar.com/research/373262.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (September 29, 2020), which can be found on our website under methodologies and criteria: https://www.dbrsmorningstar.com/research/367510/global-methodology-for-rating-non-bank-financial-institutions.
Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021):
https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The primary sources of information used for this rating include Company Documents. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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