PSEC

Business Context and Reporting Period

Company: Prospect Capital Corporation (Prospect)
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: March 31, 2012
Business Overview: Prospect is a closed-end investment company and Business Development Company (BDC) that invests primarily in senior and subordinated debt and equity of middle-market, privately-held companies. The company has diversified its portfolio away from energy-related industries, which now represent less than 10% of its holdings.

Key Financial Metrics

Note: Debt includes $121.0 million in Credit Facility, $317.5 million in Senior Convertible Notes, and $5.5 million in InterNotes.

Material Changes vs. Prior Period

• Revenue Growth: Total investment income for the three months ended March 31, 2012, increased to $95.6 million from $44.6 million in the same period in 2011. This 114% increase was driven by a larger portfolio, a $26.9 million make-whole fee from the sale of NRG Manufacturing, and increased structuring fees.
• Net Income: Net increase in net assets from operations rose to $50.2 million ($0.44 per share) for the quarter, compared to $33.8 million ($0.38 per share) in the prior year quarter.
• Portfolio Valuation: Total investments at fair value increased to $1.69 billion from $1.46 billion at June 30, 2011. This reflects new originations of $542.8 million and accretion, partially offset by repayments and sales.
• Expense Increase: Operating expenses rose to $37.6 million for the quarter (from $20.6 million prior year) due to higher advisory fees (linked to asset growth) and increased interest costs on expanded debt facilities.

Guidance, Outlook, and Material Events

• NRG Manufacturing Sale: On February 2, 2012, Prospect sold its investment in NRG Manufacturing for $123.3 million. This transaction generated a realized gain of $24.8 million and a $26.9 million make-whole fee recorded as interest income.
• Energy Solutions Restructuring: Prospect reorganized its energy holdings into Energy Solutions Holdings, Inc. The sale of Gas Solutions assets in January 2012 generated significant earnings and profits, resulting in increased dividend income from this portfolio company.
• Deb Shops Impairment: Deb Shops, Inc. filed for bankruptcy. Prospect recorded a realized loss of $14.6 million for the full amortized cost of its debt position, as the reorganization plan eliminates the debt with no payment.
• First Tower Acquisition: On March 19, 2012, Prospect entered a definitive agreement to acquire 80.1% of First Tower Corp. for $110.2 million in cash and approximately 14.5 million shares of common stock. Closing is expected in the second quarter of 2012.
• Capital Facilities: Prospect renegotiated its credit facility in March 2012, expanding commitments to $650 million (with $410 million extended as of March 31). The company also issued $5.5 million in Prospect Capital InterNotes.
• Valuation Volatility: Significant unrealized depreciation occurred in the quarter due to write-downs in Airmall, H&M Oil & Gas, and Stryker Energy, partially offset by appreciation in Ajax, Energy Solutions, and R-V Industries.

Investor Verification Checklist

• Non-Accrual Status: Verify the status of nine loan investments on non-accrual status (including Borga, H&M Oil & Gas, and Stryker Energy), which represented $170.1 million in principal but only $39.7 million in fair value.
• Concentration Risk: Review the concentration of control investments (24.5% of portfolio) and the specific valuation methodologies used for Level 3 assets, which comprise the vast majority of the portfolio.
• Debt Covenants: Confirm compliance with the new 2012 Credit Facility covenants, including minimum portfolio yield and liquidity requirements.
• First Tower Closing: Monitor the regulatory approval and closing of the First Tower acquisition, which involves significant cash and equity consideration.
• Dividend Sustainability: Assess the sustainability of the monthly dividend ($0.1015 per share) given the mix of recurring income versus one-time fees (e.g., NRG make-whole) that boosted current earnings.