A Promising Energy Prospect

Prospect Energy (Nasdaq: PSEC) is a textbook case from which every business development company (BDC) investor should learn. This energy-focused firm makes investments in and loans to energy-related companies in the $5 million to $50 million range.

Until late last year, the company was trading at a substantial discount to its mostly cash assets, effectively offering investors the rare chance to buy a dollar for $0.90. The company wasn't without its flaws, but investors willing to risk their cash made some nice coin from its subsequent rise. So far this year, Prospect is up from $12 to $17, plus dividends.

The latest quarter was more of a transition period for Prospect. A secondary offering lowered its net asset value growth year over year. But Prospect's investment income more than doubled year over year to $6.4 million, up from $3.1 million, as the company put more cash to work with greater success.

More importantly, Prospect's dividend continued to increase, nearly doubling year over year to $0.38 per share. The secondary offering earlier this year, at prices above NAV, gives Prospect more cash to invest for shareholders. Given its early success in doing so, I see substantial upside to Prospect's current low NAV multiple of 1.2.

However, like I said above, there are warts on this company, and investors should be comfortable with these issues before investing. Although Prospect CEO John Barry has some experience in the energy sector, his background is primarily in the investment-banking field. In addition, the company has churned through three CFOs and an auditor resignation in slightly more than two years as a public company. It's perhaps most worrying that top management has only a small stake in the company, with Barry owning only about 146,000 shares, or 1% of the company. (Other key management players own far less.)

With American Capital (Nasdaq: ACAS) recently focusing on the energy sector for investments as well, it can be a crowded field. That said, Prospect does have a huge hit on its hands in its Gas Solutions investment, whose recent returns have exceeded 30%. (Until its dismissal this past February, a lawsuit had hindered the company's ability to obtain full value from Gas Solutions.)

While Prospect is quite a cheap BDC, I am growing more cautious about investing in the energy sector nowadays, and a strong management team is higher on the list my list of important factors. Investors seeking more palatable investments in the BDC or energy sector might consider fellow BDC Apollo Investments (Nasdaq: AINV), more direct players like Chesapeake (NYSE: CHK), or Motley Fool Hidden Gems picks Dawson Geophysical (Nasdaq: DWSN) or OYO Geospace (Nasdaq: OYOG).

We've developed further Foolishness:

• American Capital is an investing gorilla.
• Private equity comes to the masses.
• Harris and Harris's (Nasdaq: TINY) investment is getting closer to paying off.

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Fool contributor Stephen Ellis does not own shares in any companies mentioned. You can view the stocks he owns and check out his 99th-percentile ranking in Motley Fool CAPS , the Fool's new stock-rating community. Harris & Harris is a Rule Breakers pick. The Motley Fool has adisclosure policy.