DBRS Morningstar Confirms the Ratings of Prospect Capital Corporation at BBB (low); Trend Stable

DBRS, Inc. (DBRS Morningstar) confirmed the ratings of Prospect Capital Corporation (PSEC or the Company), including its Long-Term Issuer Rating and Long-Term Senior Debt, both at BBB (low). 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. The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS
The ratings reflect the Company’s good franchise underpinned by its long industry presence and solid management team, diverse funding profile and low leverage. Over the past year, PSEC expanded its investment portfolio through strong acquisition volumes while registering sound earnings. The ratings also consider the riskiness of the Company’s investment portfolio due to its sizeable exposure to subordinated investments as well as from concentrations in real estate, consumer finance and structured investments.

The Stable trend reflects our expectation that PSEC will continue to exhibit solid operating performance accompanied by risk management discipline and capital management prudence, including the maintenance of its leverage within its target range. That said, a material spillover to the U.S. economy from the current geopolitical developments in Europe or from heightened inflationary pressures, present downside risks to our expectations.

RATING DRIVERS
Strengthening the risk profile through a greater proportion of first lien loans in Prospect Capital’s investment portfolio, while reducing the proportion of CLOs, consumer finance, and real estate, would result in a ratings upgrade. Conversely, a material and prolonged weakening in credit performance indicating increased risk appetite and/or a significant decline in the cushion relative to the debt facility covenants or regulatory requirements would result in a ratings downgrade.

RATING RATIONALE
The Company’s good franchise is underpinned by its long track record of expertise, scale, broad origination platform and a diverse set of investment strategy capabilities. PSEC is one of the oldest and largest business development companies (BDCs) with approximately two decades of operation, $7.1 billion in total assets and 127 investments across 39 industries at December 31, 2021 (YE21). PSEC primarily provides secured debt financing to middle-market companies but also invests in a variety of yield oriented, credit-related strategies. These investments enhance the Company’s origination flexibility and portfolio diversity but also raise the risk profile of its balance sheet. Through its longevity and gained scale, PSEC has developed an extensive deal sourcing network of entrenched relationships with private equity sponsors, syndicators, intermediaries and portfolio companies that broaden the optionality of its investment universe. PSEC’s franchise is also bolstered by its experienced and long-tenured management team that has effectively navigated the Company through challenging economic and investment environments.

The Company has historically exhibited consistent and resilient earnings generation capacity. PSEC’s investment portfolio has also generated fairly stable yields (defined as net investment income-to-average investments at cost) over the past five years of approximately 5%, slightly above the DBRS Morningstar BDC peer group median. Nonetheless, a noteworthy portion of interest income is derived from payment-in-kind (PIK) interest and equity investments in CLOs. Specifically, in 1HFY22 (six months ended December 31, 2021) the Company’s interest income from structured credit investments accounted for 12% of total investment income while PIK interest accounted for 10%. Following sound operating results for FY21 (fiscal year ended June 30, 2021), in 1HFY22, PSEC generated a net increase in net assets resulting from operations of $465.7 million, compared to $473.7 million in 1HFY21, driven by a smaller increase in unrealized gains even as net investment income increased to $166.9 million, up 20% year-over-year (YoY). Further, the Company’s net investment income adequately covered common and preferred dividend distribution in excess of nearly 11% in 1HFY22 and 3% in FY21. In the near-to-medium term, PSEC’s net investment income is poised to benefit from the rising interest rate environment given its asset sensitive balance sheet.

We view PSEC’s risk profile as being elevated given its meaningful exposure to the inherently riskier subordinated debt and equity investments. Specifically, as of YE21, out of the total investment portfolio (at FV), subordinated secured debt accounted for 19.5%, subordinated structured notes for 10.6%, while equity positions accounted for 23.1%. Collectively, the portion of these subordinated and equity investments accounted for nearly 53% of the investment portfolio, essentially unchanged YoY, and compared to the DBRS Morningstar BDC peer median of approximately 20%. Additionally, nearly 38% of PSEC’s debt investments are associated with non-sponsored backed companies. That said, the Company’s portfolio risk exposure is partially mitigated by its well-established risk management processes embodied in the assessment of investment opportunities, underwriting, monitoring as well as restructuring capabilities. We also view favorably the Company’s assignment to third-party independent evaluation firms for the determination of each portfolio company’s FV on a quarterly basis. The credit performance of the investment portfolio improved slightly over the past year with non-accruals as a percent of total portfolio at cost were 2.6% at YE21, down from 3.5% at YE20.

The Company has a solid funding profile from diversified funding sources and an extensive investor base. PSEC’s funding profile is also supported by low balance sheet encumbrance and a staggered debt maturity profile that is appropriately aligned with the investment portfolio’s maturities. At YE21, senior unsecured debt of $1.9 billion accounted for 80% of total debt outstanding, consisting primarily of institutional notes, retail notes sourced through weekly programmatic issuance as well as convertible notes. Furthermore, 71%, of PSEC’s total assets were unencumbered, albeit mostly comprised of intrinsically illiquid assets. The Company’s secured debt is associated with a revolving credit facility maturing in 2026 with total committed capacity of $1.5 billion that encompasses commitments from a diversified group of 43 financial institutions. Out of the total unsecured outstanding debt of $1.9 billion at YE21, just 3% matures in 2022 while 19% and 48% matures within each of the subsequent two-year periods, respectively. As of YE21, PSEC had ample readily available liquidity of $790 million, including cash and available borrowing capacity based on previously pledged collateral.

The Company has a track record of disciplined balance sheet management by maintaining leverage close or even below its desired target levels and mostly below the DBRS Morningstar peer median. At YE21, PSEC’s leverage ratio, defined as debt-to-equity and including preferred stock in total equity, was 0.52x, comfortably below its target leverage of 0.70x to 0.85x (on a net debt basis and reported as such 0.51x at YE21). Additionally, PSEC has a fairly sizeable capital regulatory cushion of approximately $2.7 billion implying that the total investments at fair value need to decline by nearly 39% before reaching its regulatory leverage limit. Since the launch of its programmatic perpetual convertible preferred stock issuance in August 2020 and up to March 2022, the Company has issued approximately $600 million through multiple distribution channels, inclusive of the $150 million of a listed perpetual preferred issuance completed in July 2021. While preferred stock is considered debt in regard to regulatory leverage requirements, if needed, PSEC has the optionality on its convertible preferred to convert it to common equity to boost its capital base in order to meet the mandated regulatory limits.

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 2, 2021): https://www.dbrsmorningstar.com/research/383936/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.

The primary sources of information used for this rating include Morningstar, Inc. and 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.

DBRS, Inc.
140 Broadway, 43rd Floor
New York, NY 10005 USA
Tel. +1 212 806-3277