Prospect Capital (PSEC)

Blyth Fund Financials Group

Tommy Fan Bill Kwai Nick LaGrandeur David Lopez Nick Burakoff Jacobo Ochoa

Vedant AhluwaliaHabib OlapadeSophia HuardAndrea WangAlex Mack

Business Overview

• Prospect Capital is a business development corporation (BDC)–Similar to a private equity firm, but welcomes public investors through common stock

- Invests in senior and subordinate secured loans, mezzanine loans and equity of small-sized businesses ($50M to $2B in annual revenues).

–Highly fragmented Industry, with no major dominating players (the top 50 companies of the sector contribute less than 25% to the overall revenue of this sector).

–Asset managers don’t quite know how to value BDCs

• Classified as a business development corporation under the Investment Company Act of 1940

–Must pay out at least 90% taxable income in dividends. In return, no corporate tax

–At least 70% of its assets must be in private or thinly-traded, public US corporations

PSEC Investment Thesis

• Significant growth in performance metrics over the past 5 years

• Regulatory benefits such as high dividend yields

• Diversified Exposures

• Relatively Undervalued

Portfolio Growth

Total Assets

Growth in Net Investment Income

Increasing Revenue distribution

Superior cumulative returns

Increasing Origination

• Increased origination → improved IRR–Q3 2014: sharp slowdown in its originations - company posted $887M in new investments. But:

repayments also spiked higher to $862.9M. So: investments net of repayments were only $24M.

–However: in Q4 2014, new investments totaled $522.7M, while repayments were $223.7M. Result:  improved $299M in investments net of repayments.

–Q4: PSEC was able to score many smaller sub-$100M sized deals, which should result in improved IRR.

Diversified debt investments

Diversified sector investments

• Highly sector diversified holdings with the highest percentage holding in CLO’s (18% based on fair value).

• Portfolio consists of long term investments.

• At December 31, 2014, approximately $6,523,723, or 176.0%, of net assets are invested in 134 long-term portfolio investments and CLOs.

• Many of these are PE-firm sponsored (46%)

Lender Diversification

Regulatory Benefits

• High dividend yields.

• Heavily invested in US Middle Market, which accounts for 40 percent of US GDP.

Undervalued according to overreaction

• When management cut dividends from 11.1 cents to 8.333 in December 2014 to reflect the shift towards more secured debt, investors panicked, causing its stock price to drop by ~20%

• Cut resulted from a shift in management’s risk goals

• Despite that, dividend yield still at 11.59%.

• It is currently trading at a 21% discount relative to the Net Asset Value

Undervalued compared to peers

Company NameFiscal Period

RevenueEBITDA Margin

P/E RatioMarket Cap

to Book Value

Dividend Yield

Prospect Capital 12/31/2014 615.8 52.5% 9.18x 0.83x 11.59%

   

Average 284.5 44.7% 13.04x 1.05x 9.44%

   

Apollo Investment 12/31/2014 427.9 31.5% 11.80x 0.92x 10.27%

Ares Capital 09/30/2014 1,024.5 57.3% 9.01x 1.04x 8.79%

BlackRock Kelso Capital 09/30/2014 206.4 55.6% 6.14x 0.88x 9.57%

Fifth Street Finance 12/31/2014 280.3 16.9% 19.23x 0.77x 10.17%

Golub Capital BDC 12/31/2014 123.6 53.2% 12.51x 1.14x 7.21%

Hercules Tech Growth Cap 09/30/2014 156.5 48.9% 13.52x 1.52x 7.97%

Main Street Capital 09/30/2014 157.4 66.7% 13.17x 1.47x 6.79%

Medley Capital 12/31/2014 147.7 14.2% 22.00x 0.81x 12.68%

New Mountain Finance 09/30/2014 131.8 55.4% 10.34x 1.04x 9.13%

PennantPark Investment 12/31/2014 188.9 25.2% 12.68x 0.91x 11.78%

DCF Valuation

Applicable Risks

•CLO exposure

•Interest rate risk

•LBO debt funding

Risks: CLO’s

• What are they: A security backed by a pool of debt, often low-rated corporate loans. Collateralized loan obligations (CLOs) are similar to collateralized mortgage obligations, except for the different type of underlying loan.

• Exposure: Prospect Capital also has exposure to oil/energy in its CLO investments that account for 18.5% of the portfolio.

• Fast-growing market: $55B in 2012 to $124B in 2014

• Not a threat for 2015:

–Such assets are being heavily monitored by the government and market participants after CDO’s, and thus have a very small likelihood of being overvalued significantly.

Risks: Interest Rates

• Problem: “net investment income is affected by the difference between the rate at which we invest and the rate at which we borrow”

–According to the industry: increased interest rates should reduce the value of its portfolio and raise the cost of its own capital

• Safe for 2015 as rise is in near future and exposure is positive− Increase in interest rates of 5.00% would increase net investment income by $0.14 per share per annum or $48.9 million for the 6 months remaining in FYE 2015 and $0.33 per share per annum or $116.6M for FYE 2016− 95% of interest bearing assets(2) are floating rate and approximately 94% of liabilities fixed rate as of 12/31/2014

Risks: LBO

• Problem: PSEC specializes in debt produced by LBOs, which can yield high returns. This is accompanied by an increased risk of default (coupon payments for firms with LBO debt correlated with market performance).

• Should not cause much problem in 2015:

1. This risk is highly systematic: depends generally on the overall US economic condition. Since we have been out of the economic crisis for a while, and don’t foresee one in the near future, we feel that taking a hefty premium (~11% dividend yield) for holding this risk is valuable.

2. PSEC taking steps to lower overall risk exposure: increased its portfolio allocation to first-lien loans (i.e. secured debt)

Conclusion

• DCF projection is $14.50, currently trading at $8.63 (as of Sunday)

• Stock is currently undervalued.

• Has a historically consistent dividend yield of over 10%.

• Provides a diversified exposure to US small cap and private companies which are illiquid and highly risky to hold individually.

• Risks are not of concern until end of 2015 by when we will have re-evaluated the portfolio 2 times!

Cases for Re-evaluation:

• If the stock price drops by $7.5, we will need to re-evaluate the thesis as PSEC as it will have had a deviation of 7% from nearest trough signaling that the next support will only come near 6.58 which is the all time low.

• If dividend yield drops below 8%, we will need to re-evaluate the companies agendas.