Prospect Capital (NASDAQ:PSEC) is one of the largest business development companies in the sector, ranking only second to Ares Capital Corporation. Nonetheless, Prospect Capital has reached a respectable size with a market capitalization of $3.6 billion and more than $7 billion in capital under management.
Like most business development companies, Prospect Capital focuses on providing debt capital to U.S. middle market companies which usually generate an annual EBITDA somewhere between $5-150 million. Prospect Capital is currently invested in 138 portfolio companies and has had quite a successful track record in increasing its assets and investment income over the last five years.
Business development companies are largely investment vehicles, that allow investors to invest in non-publicly traded companies which would normally be out of reach for most investors.
Moreover, the public listing of business development companies adds a layer of liquidity which significantly adds to the attractiveness of Prospect Capital as a dividend play: Investing in private companies and being able to trade your shares in Prospect Capital on a daily basis really is a neat deal.
Given that most business development companies avoid corporate taxation if they distribute more than 90% of their earnings, BDCs are high-yield income investments.
This has profound implications for the risk/return characteristics of investments such as Prospect Capital.
For the most part, net asset values of BDCs are relatively stable. Since the majority of earnings are distributed to shareholders on a monthly basis, investors should expect the majority of their total returns to come in the form of dividends.
Prospect Capital's capital appreciation potential is largely limited and investors can reasonably expect the company to trade at or around its reported net asset value of $10.68 for the foreseeable future.
The dividends are where the money is.
Business development company have experienced extraordinary growth lately, thanks to the consolidation of the banking sector and the reluctance of large banks to provide middle market companies with enough debt capital to finance their growth projects.
As a result, companies like Prospect Capital swooped in and ruthlessly took advantage of the opportunity as evidenced by its skyrocketing portfolio value and net investment income over the last five years.
Reflecting the underlying growth in portfolio size, Prospect Capital has transformed itself into a formidable dividend payer who delights its investors with regular cash flow every month.
More importantly, Prospect Capital allowed investors to participate in the massive boom in the BDC sector during the financial crisis by paying out remarkable amounts of cumulative dividends. Total value: $13.26 per share.
Prospect Capital currently pays investors a monthly distribution of $0.1106 which translates into a forward dividend yield of 12.5%.
Also, Prospect Capital has upheld high monthly distributions to shareholders for quite a while. The BDC paid at least $0.10 per share since 2010 which should make investors sleep even more peacefully.
Generally speaking, investors should not expect significant gains from capital appreciation, unless it is in periods of extraordinary volatility.
For instance, in May 2014 Prospect Capital came into the crosshairs of the U.S. Securities and Exchange Commission which argued, that the accounting treatment of certain wholly owned holding companies required a restatement of Prospect Capital's financial statements. Class action lawsuits were being filed against Prospect Capital as a result which put further pressure on its stock price and pushed the stock below $10.
On June 10, 2014 Prospect Capital announced, that no restatement of its historical financial statements was required which caused the stock to regain the $10 level quickly.
Last week, Prospect Capital announced, that class action complaints against the company were voluntarily dismissed.
Net asset value
Investors should expect, unless in extraordinary situations like the one mentioned above, little volatility and trading opportunities in Prospect Capital. Prospect Capital is likely to continue to trade at net asset value without any large moves either to the down- or upside. The BDC currently trades at a 0.5% discount to its net asset value of $10.68.
Material discounts or premiums to reported net asset values are not very common in the BDC sector.
For comparison purposes, Ares Capital Corporation, the BDC industry-leader with a market capitalization of $5.3 billion, trades at only a 9% premium to book value while Apollo Investment Corporation trades at a 1% discount to book value.
The number two in the BDC market in terms of market capitalization, Prospect Capital, convinces with a strong growth and dividend record as well as a 12.5% dividend yield.
Furthermore, the company has proven that it can uphold high dividend payouts for more than four years which should provide income investors with peace of mind.
Kingkarn Amjaroen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.