Morningstar DBRS Confirms Prospect Capital Corporation's Long-Term Credit Ratings at BBB (low); Revises Trends to Stable From Positive

DBRS, Inc. (Morningstar DBRS) confirmed both the Long-Term Issuer Rating and Long-Term Senior Debt credit ratings of Prospect Capital Corporation (PSEC or the Company) at BBB (low). At the same time, Morningstar DBRS changed the trend on all credit ratings to Stable from Positive. The Company's Intrinsic Assessment (IA) is BBB (low) while its Support Assessment is SA3, resulting in the final credit rating being positioned in line with the IA.

KEY CREDIT RATING CONSIDERATIONS
The confirmation of the credit rating and the revision of the trend to Stable from Positive reflect PSEC's lower operating results over the past year, which were partially impacted by certain realized and unrealized losses. Moreover, while declining significantly, payment-in-kind (PIK) income remained at elevated levels while non-accruals (as a percentage of cost) increased. The credit rating confirmations also reflect the Company's solid franchise, which is supported by its expertise and longevity in the industry, diverse funding profile, and appropriate capitalization. The credit ratings also factor PSEC's portfolio profile given a portion of subordinated investments, real estate, consumer finance, and structured investments.

PSEC has announced positive strategic business optimization initiatives, which entail a continued focus on reducing subordinated portfolio investments (second lien and structured notes) and prudent divestment of equity linked positions (including real estate and other corporate investments), which should better position the Company in the longer term. While Morningstar DBRS views the initiatives favorably, we note there is execution risk in the initiatives that will likely take some time to fully implement. Over the last 12 months, the Company continued to improve its credit risk profile by increasing the portion of first-lien investments, but the overall portion remains below the Morningstar DBRS BDC median.

The Stable trend also considers the current uncertainty surrounding the U.S. economic outlook, suggesting the prospect of slower macroeconomic growth within a prolonged higher interest rate environment, which could pressure middle market companies' performance leading to higher non-accruals and PIK income. In this environment, Morningstar DBRS anticipates the impact on PSEC's operating performance to be manageable, and still supportive of the current credit ratings.

CREDIT RATING DRIVERS
The credit ratings would be upgraded if the Company materially improves its risk profile through reducing certain large concentrations, including a further reduction in CLO investments as well as equity investments, leading to a sustained improvement in operating results. Conversely, a notable increase in regulatory leverage that reduces the Company's cushion to the Asset Coverage Ratio and/or weakening in operating results beyond current expectations would result in a downgrade of the credit ratings.

CREDIT RATING RATIONALE
Franchise Building Block Assessment: Good
PSEC's franchise strength is underpinned 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 PSEC through various economic and investment environments. With an investment portfolio totaling $7.1 billion at fair value (FV) at December 31, 2024 (YE2024), across 114 portfolio companies in 33 industries, PSEC is one of the largest BDCs with a broad deal-sourcing network with established relationships encompassing private-equity sponsors, syndicators, intermediaries, and portfolio companies. While PSEC is mainly focused on providing secured debt financing to private middle-market companies, it has historically also invested in various yield-oriented, credit-related strategies that augment its origination flexibility and portfolio diversity, but which could amplify the balance sheet riskiness in times of market unease.

Earnings Building Block Assessment: Moderate
PSEC has historically exhibited a largely profitable track record on a fiscal-year basis. Nonetheless, in recent quarters, lower market interest rates, a slowdown in net loan originations, as well as variability in FV marks and realized losses have reduced bottom line results. In H1 F2025 (six months ended December 31, 2024), PSEC reported a net decrease in net assets resulting from operations (net loss) of $134.1 million compared with a net increase in net assets resulting from operations (net income) of $88.9 million in H1 F2024. The Company recorded net unrealized losses of $163.8 million and a net realized loss of $147.0 million, most of which was attributed to net realized losses of structured subordinated notes. Of note, effective in F2024 (ended June 30, 2024), PSEC's policy modification related to the timing recognition of realized losses for certain collateralized loan obligation (CLO) equity investments has resulted in reporting realized losses (versus unrealized losses previously), even as the underlying cash flows and valuations from these investments were unaffected. For H1 F2025, the net investment income decreased to $176.3 million, down 21% year over year (YOY), mostly driven by an 11% decline in interest income while investments at FV declined 7% YOY (and were down 8% at cost). Furthermore, payment in kind (PIK) interest income totaled $53.3 million, down 22% YOY, but accounted for an elevated 14% of total investment income (versus 15% in H1 F2024). However, approximately 63% of PIK was associated with control investments (typically used as incremental investments for organic growth, bolt-on acquisitions or improving efficiencies) while 37% was associated with non-control/non-affiliate investments (or 5% of total investment income).

For F2024, net income totaled $262.8 million compared with a net loss of $101.6 million in F2023, driven by essentially flat net investment income and a smaller net realized and unrealized losses. Morningstar DBRS expects the continuing amortization of the CLO portfolio will continue to be a short-term headwind to reported earnings.

Risk Building Block Assessment: Moderate
The Company has an elevated profile given its exposure to inherently riskier U.S. middle market lending along with its notable investment portfolio concentration in commercial real estate, non-prime consumer finance, and subordinated structured notes. Over the past year, PSEC continued to reduce the overall riskiness of its investment portfolio (at FV) by increasing the portion of its first-lien loans to 64.9% at YE2024 from 58.7% at YE2023 while reducing the portion of its second-lien loans to 10.2% from 15.5%. That said, PSEC's first-lien loan composition remains lower than that of the Morningstar DBRS BDC peer group's median of 83%. Meanwhile, the portion of the subordinated structured notes contracted further to 5.8% at YE2024 from 7.9% at YE2023, a trend that's anticipated to continue given the ongoing portfolio amortization of these investments. The Company's equity investments are mostly in controlled portfolio companies with long-term investment horizons and appreciation potential (FV 1.6x above cost at YE2024). Credit performance weakened over the past few quarters, with non-accruals as a percent of total portfolio (at cost) increasing to 3.8% at YE2024, up from 2.8% in the prior quarter and up from 2.2% at YE2023.

Funding and Liquidity Building Block Assessment: Moderate
PSEC has a diversified funding profile that benefits from a range of funding channels and a broad investor base. At YE2024, unsecured debt accounted for 85% of the Company's total debt outstanding, contributing to PSEC's low balance sheet encumbrance. Pro-forma for the recent repayment of convertible notes in March 2024, unsecured debt outstanding totaled $1.6 billion, comprised of institutional notes and retail notes sourced through weekly programmatic issuance. The Company's secured debt entails a revolving credit facility maturing in June 2029 with a total committed capacity of $2.1 billion from a diversified group of 48 lenders, of which $1.05 billion is readily available liquidity based on the pledged collateral, in addition to the $301.5 million outstanding at YE2024. The Company's debt maturity profile is staggered and is properly aligned with the investment portfolio's maturities. There are immaterial maturities of unsecured debt through June 2025 followed by maturities of $430.9 million in the subsequent 12-month period. Given the current elevated interest rate environment, PSEC intends to increase its use of the more funding-cost-efficient credit facility over the near-term.

Capitalization Building Block Assessment: Moderate
PSEC has historically demonstrated a disciplined balance sheet management approach by maintaining prudent leverage levels with adequate cushion relative to regulatory limits. The Company's regulatory leverage ratio (defined as debt-to-equity with preferred stock included as part of total debt), was solid at 1.1 times (x) as of YE2024, essentially flat over the past five quarters, and in line with the Morningstar DBRS BDC median. At YE2024, PSEC's asset coverage ratio was at 185.3%, above the regulatory required ratio of 150%. Morningstar DBRS estimates the Company's cushion to regulatory leverage limits to be approximately $1.6 billion, implying PSEC would need to incur a loss of 22% of its investment portfolio at FV before breaching the regulatory leverage limit. In addition to managing to regulatory requirements, PSEC manages leverage based on a net debt leverage ratio, with perpetual preferred stock treated as equity. At YE2024, the net leverage ratio was 0.40x at YE2024, down from 0.46x at YE2023 (one of the lowest in the Morningstar DBRS BDC coverage). In November 2024, the Company reduced its monthly common stock dividend to $0.045 from $0.06 per share. The common and preferred dividend coverage from net investment income was 103.5% in H1 F2025 (as adjusted for the reduction in common dividend) compared with 106.1% in FY2024 and 117.4% in FY2023. Over the past five fiscal years, common and preferred dividend coverage from net investment income has averaged 108%.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) at https://dbrs.morningstar.com/research/437781.

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

The principal methodology is the Global Methodology for Rating Non-Bank Financial Institutions (November 19, 2024): https://dbrs.morningstar.com/research/443208. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

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

The primary sources of information used for this credit rating include Morningstar, Inc. and company documents. Morningstar DBRS considers the information available to it for the purposes of providing this credit rating was of satisfactory quality.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit 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. Morningstar DBRS' trends and credit ratings are under regular surveillance.

For more information on this credit or on this industry, visit https://dbrs.morningstar.com.

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