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 trend on all 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 confirmation of the ratings reflect the Company’s solid franchise which is supported by its scale, expertise and longevity in the industry, its profitable track record, diverse funding profile and low leverage. The ratings also consider the Company’s relatively higher risk portfolio due to the sizeable presence of subordinated and equity investments, as well as asset class concentrations in real estate, consumer finance and structured investments.

The Stable trend reflects our expectation that the Company will continue to generate sound operating results while maintaining credit risk discipline and prudent leverage levels. That said, a contraction or sluggishness in U.S. economic activity as a result of the Fed’s tightening measures or a potential spillover from the recent turmoil in the banking sector present key downside risks to our expectations.

RATING DRIVERS
The ratings would be upgraded if the Company further improves its overall risk profile by increasing the proportion of its secured first lien loan portfolio closer to the average of the higher rated peers while reducing the proportion of its outstanding investments in structured notes, consumer finance and real estate. 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
PSEC’s franchise strength is anchored by its scale, well-established market presence and long operating history. The Company’s franchise is also supported by its experienced management team that as one of the earliest publicly listed business development companies (BDCs) has navigated it through various economic and investment cycles. With an investment portfolio totaling $7.8 billion at fair value (FV) at December 31, 2022, across 130 investments in 37 industries, PSEC is one of the largest BDCs with an extensive deal sourcing network of established relationships encompassing private equity sponsors, syndicators, intermediaries and portfolio companies. While the Company mainly 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 at the same time could amplify the risk profile of its balance sheet.

The Company has mostly remained profitable on an annual basis since inception. Even though earnings volatility is typical in the BDC space due to fair value reporting, PSEC’s notable portion of equity and CLO investments partly exacerbates such variability. The Company generated solid operating results for the fiscal year 2022 (or FY22, twelve months ending June 30, 2022), reporting a net increase in net assets resulting from operations (net income) of $582.6 million. The results were driven by growth in net investment income as well as from unrealized gains. In 1HFY23 (six months ending December 31, 2022), PSEC reported a net decrease in net assets resulting from operations (net loss) of $20.2 million as bottom-line results were adversely impacted by unrealized losses due to fair value marks. Positively, net investment income increased sequentially for each quarter over the past year and adequately covered common and preferred dividend distributions in excess of approximately 12% in FY22 and 20% in 1HFY23. With 83% of its interest earning investment portfolio comprised of floating rate assets, we expect PSEC’s net investment income will benefit from any additional rate increases.

The Company’s risk profile is considered elevated given its sizeable exposure to subordinated investments of U.S. middle market companies as well as from the notable investment portfolio concentration in CLOs, real estate and consumer finance. At December 31, 2022, the inherently riskier (relative to first lien) subordinated portion of the Company’s investments collectively accounted for 47% of total investment portfolio (at FV) comprised of second lien debt (18.5%), subordinated structured notes (9.0%) and equity investments (19.3%). While the portion of the portfolio comprised of subordinated investments improved from 53% at December 31, 2021, it remains well above the DBRS Morningstar BDC peer median of 20%. We would view favorably further progress in the reduction of these subordinated exposures particularly the subordinated structured notes. Meanwhile, approximately 19% of the Company’s debt investments are associated with non-sponsored backed companies, which are viewed less favorably by DBRS Morningstar vis a vis sponsored-backed loans given the absence of a sponsor with its equity at risk.

PSEC’s portfolio risk exposure is mitigated by its well-defined risk management processes embedded in new investment assessments, underwriting, monitoring and restructuring capabilities. Additionally, we consider the Company’s use of an independent third party valuation firm for each investment on a quarterly basis as the best in class standard for the BDC sector. Credit performance has been acceptable with non-accruals as a percent of the total portfolio at cost at 2.6% at December 31, 2022, up from 2.3% on a linked quarter basis, but unchanged year-on-year.

PSEC has a solid funding profile with access to diversified funding channels and a broad investor base. At December 31, 2022, unsecured debt accounted for 71% of the Company’s total debt outstanding and thereby resulting in low balance sheet encumbrance. Specifically, the unsecured debt outstanding of $1.9 billion was comprised of institutional notes, retail notes sourced through weekly programmatic issuance and convertible notes. PSEC’s secured debt is related to a revolving credit facility that entails commitments from a highly diversified financial group of 49 lenders with a total committed capacity of $1.7 billion, of which $805.6 million is readily available liquidity based on the pledged collateral at December 31, 2022. The Company has a staggered debt maturity profile which is properly aligned with the investment portfolio’s maturities. At December 31, 2022, 15% of the unsecured debt outstanding was maturing in 2023 and was repaid in March 2023, while just 4% matures in 2024 and 9% in 2025.

PSEC has historically demonstrated a disciplined capital management approach by maintaining leverage close or below the Company’s target leverage. The Company targets leverage of 0.70x to 0.85x, defined by PSEC as net debt-to-equity and including preferred stock in total equity. At December 31, 2022, the Company’s leverage per this definition was 0.49x. While the perpetual convertible preferred stock provides PSEC with added optionality, flexibility and support to the Company’s capitalization, the perpetual, convertible preferred stock is treated as debt for BDC regulatory leverage requirements. Regulatory leverage was a solid 1.0x at December 31, 2022, in-line with the DBRS Morningstar median, and with a notable common equity cushion of nearly $2 billion implying that the total investments at fair value at December 31, 2022 would have to decline by around 25% before reaching its regulatory leverage limit.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
General Considerations
There were no Environmental/ Social/ Governance factor(s) that had a significant or relevant effect on the credit analysis

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions: https://www.dbrsmorningstar.com/research/402314/global-methodology-for-rating-non-bank-financial-institutions (September 2, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria:: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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 rating was initiated at the request of the rated entity.
The rated entity or its related entities did participate in the rating process for this rating action.
DBRS Morningstar had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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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