PSEC

Business Context and Reporting Period

Company: Prospect Capital Corporation (Prospect Capital)

Filing Type: Form 10-Q (Quarterly Report)

Reporting Period: Three months ended September 30, 2008

Business Overview: Prospect Capital is a closed-end investment company organized as a Business Development Company (BDC) and a Regulated Investment Company (RIC). It primarily invests in senior and subordinated debt and equity of middle-market, privately-held companies, with a historical concentration in energy and industrial sectors. As of September 30, 2008, the company held 31 long-term portfolio investments.

Key Financial Metrics

Note: Cash and Cash Equivalents calculated as Cash ($1,269) + Money Market Funds ($28,658).

Material Changes vs. Prior Period

• Revenue Growth: Total investment income increased 132% to $35.8 million, driven by a larger portfolio ($549.3M vs. $363.6M in Q3 2007) and a significant one-time gain of $12.6 million from the settlement of net profits interests in IEC Systems LP and Advanced Rig Services LLC.
• Expense Increase: Total operating expenses rose 63% to $12.3 million. This was primarily due to a higher income incentive fee ($5.9M vs. $2.0M) resulting from strong net investment income performance and increased base management fees due to asset growth.
• Unrealized Losses: The company recorded a net unrealized depreciation of $11.1 million, contrasting with a $0.7 million appreciation in the prior year. This was driven by write-downs in Worcester Energy Partners, Inc. (WEPI), Integrated Contract Services, Inc., and Iron Horse Coiled Tubing, Inc., partially offset by appreciation in Gas Solutions Holdings, Inc. (GSHI).
• Leverage: Borrowings under the $200 million Rabobank credit facility increased significantly to $131.7 million (from $91.2 million at June 30, 2008) to fund new investments.

Outlook, Risks, and Management Commentary

• Investment Activity: The company completed three new investments and several follow-on investments totaling approximately $70 million during the quarter. Notable new deals included debt financing for Castro Cheese Company, TriZetto Group, and Biotronic NeuroNetwork.
• Portfolio Valuation Risks: Management highlighted enhanced scrutiny on several control investments. WEPI and Integrated Contract Services are under review due to poor operating results or covenant defaults. However, management believes collateral is adequate for underperforming assets like Conquest Cherokee and Iron Horse.
• Liquidity and Capital: The company has a $200 million revolving credit facility maturing in June 2009, with $68.3 million remaining available. No new equity was raised during the quarter due to market conditions. On October 9, 2008, the Board approved a share repurchase plan of up to $20 million.
• Legal Proceedings: The company successfully dismissed claims from Dallas Gas Partners, L.P. and obtained an arbitration award in its favor against a former potential borrower. No material changes to risk factors were reported.
• Non-Accrual Status: As of September 30, 2008, loans totaling $54.4 million to Integrated Contract Services and WEPI were placed on non-accrual status.

Investor Verification Checklist

• Non-Accrual Exposure: Verify the status and recovery prospects of the $54.4 million in loans to Integrated Contract Services and WEPI currently on non-accrual status.
• Valuation Methodology: Review the Board's fair value determinations for Level 3 assets, specifically the write-downs in WEPI and Integrated Contract Services versus the write-ups in GSHI.
• Debt Covenants: Confirm compliance with the Rabobank credit facility covenants given the increased leverage and concentration of collateral (94.3% of net assets pledged).
• One-Time Income: Assess the sustainability of net investment income excluding the $12.6 million one-time gain from net profits interest settlements.
• Share Repurchase Plan: Monitor the execution of the newly approved $20 million share repurchase plan and its impact on NAV.