Executive Summary / Key Takeaways

• Strategic Pivot to First-Lien Dominance: Prospect Capital Corporation is undergoing a significant portfolio repositioning, shifting decisively towards first lien senior secured middle-market loans, which now constitute 70.5% of its investment portfolio, up 642 basis points from the prior year. This strategy targets companies with less than $50 million in EBITDA, aiming for wider spreads, higher SOFR floors, and stronger covenants.
• Portfolio De-risking and Capital Redeployment: The company has nearly completed its exit from subordinated structured notes (CLOs), reducing this segment to a mere 0.6% of its portfolio, and is prudently divesting from lower-yielding real estate assets. Proceeds from these exits are earmarked for reinvestment into higher-yielding, core first-lien middle-market debt.
• Conservative Leverage and Robust Liquidity: Prospect Capital maintains a strong balance sheet with a net debt to total assets ratio of 30.4% as of June 30, 2025, significantly lower than many peers. It boasts $1.3 billion in combined cash and undrawn revolving credit facility commitments, supported by $4.2 billion in unencumbered assets and a $2.12 billion credit facility with 48 banks, demonstrating diversified and stable funding.
• Dividend Stability Efforts Amidst Challenges: While facing analyst concerns regarding past dividend cuts and potential NAV erosion, management has declared monthly common shareholder distributions of $0.045 per share for September and October 2025, emphasizing improved dividend coverage and balance sheet quality post-strategic adjustments.
• Differentiated Investment Platform: Prospect Capital's competitive edge lies in its deep expertise in structuring multi-level capital solutions and its extensive team, enabling a high-volume, selective deal-sourcing process in the less efficient, lower middle-market segment.

A New Chapter: Prospect Capital's Core Mandate and Strategic Evolution

Prospect Capital Corporation (PSEC) stands as a seasoned player in the business development company (BDC) landscape, with a history spanning over two decades since its IPO in July 2004. Its foundational mission has consistently been to generate both current income and long-term capital appreciation by investing in and lending to privately owned U.S. middle-market companies. This enduring objective has guided its evolution, from early structural enhancements like the formation of Prospect Capital Funding LLC (PCF) in 2007 to its pioneering role in introducing diversified financing instruments to the BDC industry.

The company is currently embarking on a significant strategic repositioning, a narrative thread that underpins its current operations and future outlook. This involves a decisive shift towards first lien senior secured middle-market loans, a reduction in exposure to second lien debt, and a near-complete exit from its subordinated structured notes (SSN) portfolio. This strategic pivot is not merely a tactical adjustment but a fundamental re-alignment designed to enhance risk-adjusted yields and streamline operations in a dynamic market environment.

In a sector characterized by intense competition for private credit deals, Prospect Capital differentiates itself through a specialized investment platform. While not a technology company in the traditional sense, its "technological edge" lies in its sophisticated investment process, extensive deal-sourcing capabilities, and expertise in crafting complex capital structures. The company's 150-person team originates thousands of deals annually, maintaining a low 0.5% "book-to-look" ratio, which speaks to a highly selective and efficient underwriting process. This operational prowess enables PSEC to target the less efficient, lower and core middle-market segments—companies with less than $50 million in EBITDA—where it can secure wider spreads, higher SOFR floors, and more robust covenants. This contrasts sharply with the "upper end of the market," often plagued by tight spreads, loose covenants, and low to no floors, as noted by management. This differentiated approach to deal origination and structuring serves as a critical competitive moat, allowing PSEC to command better terms and generate attractive, "all-weather" double-digit yields.

Strategic Repositioning: Forging a First-Lien Future

Prospect Capital's strategic pivot is evident in its evolving portfolio composition. As of June 30, 2025, first lien debt comprised 70.5% of the portfolio at cost, marking a substantial increase of 642 basis points from the prior year. This focus on senior secured positions is a direct response to market dynamics, aiming to enhance credit quality and yield stability. Concurrently, the company has actively reduced its exposure to second lien senior secured middle-market loans, with this segment decreasing by 202 basis points to 14.4% of the portfolio at cost. Further reductions are anticipated, with two additional second lien loans repaid since June 30, 2025, expected to lower the second lien mix to 13.7%.

The company's exit from its subordinated structured notes (SSN) portfolio is another cornerstone of this repositioning. This segment, which once represented a more significant portion of the portfolio, has been reduced by 781 basis points to a mere 0.6% of the investment portfolio at cost as of June 30, 2025. Management views this as a strategic move to unlock capital from a "low GAAP contributor, high cash contributor" for reinvestment into higher-returning first lien middle-market loans. Historically, this structured credit business delivered attractive cash yields, generating $2.1 billion in cumulative cash distributions through June 2024, representing 126% of the original investment. However, the shift reflects a clear prioritization of the core middle-market lending strategy.

The real estate portfolio, held through National Property REIT Corp. (NPRC), also plays a role in this capital redeployment. While NPRC represents 14% of investments at cost and has delivered a "terrific" 24% unlevered gross cash IRR on 52 exited properties through June 2025, its current income yield of 4.5% is "substantially lower yielding than our middle market book." Prospect Capital is "selectively exiting investments at a value maximizing price" from this portfolio, with six properties sold in the last six quarters, to redeploy proceeds into its core first lien senior secured middle-market loans. Management anticipates accelerating double-digit net operating income (NOI) growth in its remaining real estate portfolio, driven by abating new supply in larger cities and a slowdown in inflation impacting operating expenses, which is "quite favorable."

Financial Performance and Robust Capital Structure

Prospect Capital's financial performance in recent quarters reflects both the ongoing strategic adjustments and the broader economic environment. For the fiscal year ended June 30, 2025, the weighted average interest rate earned on performing interest-bearing assets decreased to 9.66% from 10.62% in the prior year. This decline is primarily attributed to an $82.385 million reduction in interest income from portfolio company repayments and lower SOFR rates, alongside a $21.705 million decline in structured credit securities income. However, this was partially offset by a $4.886 million increase in original issue discount (OID) accretion and prepayment penalty income. Other income for the year also saw a significant decrease of $50.448 million, mainly due to lower royalty and net revenue interests and a non-recurring NPRC structuring fee from the prior year.

Despite these revenue headwinds, the company's net investment income (NII) for the June 2025 quarter was $79 million, or $0.17 per common share. This follows NII of $83.5 million ($0.19 per share) in the March quarter and $86.4 million ($0.20 per share) in the December 2024 quarter. A positive trend is the significant reduction in payment-in-kind (PIK) income, which for the June 2025 quarter was down over 50% from the June 2024 quarter, and for the March and December 2024 quarters, was down nearly 50% from the June 2024 quarter. This suggests a shift towards more cash-pay income. Furthermore, non-accruals as a percentage of total assets improved, standing at approximately 0.3% based on fair market value and 4% based on cost as of June 2025, a reduction of 30 and 65 basis points, respectively, from the prior quarter.

Prospect Capital maintains a conservative and diversified capital structure, which is a key strength. As of June 30, 2025, its net debt to total assets ratio was 30.4%, notably lower than many industry peers. The company boasts substantial liquidity, with $1.3 billion in combined balance sheet cash and undrawn revolving credit facility commitments.

A significant 62% of its portfolio, or $4.2 billion, is held as unencumbered assets. The revolving credit facility itself is robust, with $2.12 billion in commitments from 48 banks, maturing in June 2029 and revolving until June 2028, at a competitive drawn pricing of SOFR plus 2.05%. Prospect Capital has also diversified its funding through various unsecured debt instruments—institutional non-convertible bonds, institutional convertible bonds, retail baby bonds, and retail program notes—all issued without financial covenants, asset restrictions, or cross defaults with its revolver. Unsecured debt plus unsecured preferred constitutes 77.1% of total debt plus preferred, and the company has successfully laddered its liabilities out 26 years into the future. Its weighted average cost of unsecured debt financing was 4.52% at June 30, 2025.

This diversified and conservative funding approach, coupled with its five investment-grade ratings (more than any other company in its industry), underpins its financial resilience.

Competitive Landscape and Strategic Differentiation

In the competitive BDC market, Prospect Capital faces direct competition from established players like Ares Capital Corporation (ARCC), Apollo Investment Corporation (AINV), BlackRock TCP Capital Corp (TCPC), and Main Street Capital Corporation (MAIN). These competitors vie for similar middle-market debt and equity deals across sectors such as energy, industrials, and financial services. However, Prospect Capital's strategic emphasis on the lower and core middle-market, targeting companies with less than $50 million in EBITDA, provides a distinct competitive advantage. This segment is less saturated than the upper middle-market, where competition often leads to tighter spreads, looser covenants, and lower SOFR floors. Prospect Capital's ability to secure "wider spreads, higher floors, [and] better covenants" in this less efficient market segment is a key differentiator.

Compared to larger peers like ARCC, which leverages its scale for broader deal flow, Prospect Capital's strength lies in its tailored capital solutions and focus on control acquisitions, fostering deeper operational involvement and potentially stronger pricing power. While AINV and TCPC also engage in middle-market lending, PSEC's broader investment scope, including its historical real estate and subordinated debt ventures, allows for more comprehensive capital structuring. However, this broader approach has also exposed PSEC to vulnerabilities, with analysts noting its "heavy reliance on real estate" making it "vulnerable to high interest rates" and contributing to NAV decline.

Financially, PSEC's performance trends, including revenue stability and cash flow generation, are generally comparable to its rivals. However, some competitors, particularly MAIN, are often perceived to exhibit superior operational efficiency and capital management, potentially leading to better profitability margins. PSEC's "unmatched" diversity in bank relationships, with $2.12 billion in commitments from 48 banks, is a significant competitive strength, providing stable and flexible funding. The company's strategic pivot is designed to address past criticisms and enhance its competitive standing by focusing on its most profitable and defensible lending activities.

Outlook, Risks, and Conclusion

Prospect Capital's outlook is shaped by its ongoing strategic repositioning and management's confidence in its ability to enhance net investment income. The company has announced monthly common shareholder distributions of $0.045 per share for September and October 2025, with future distributions to be announced in November. Preferred shareholder distributions are expected to continue at their contractual rates. Management anticipates that the rotation of assets from lower-yielding structured notes and real estate into higher-yielding first lien middle-market loans will boost overall portfolio yields. The real estate portfolio, in particular, is expected to see accelerating double-digit net operating income growth, driven by favorable market conditions.

However, the investment thesis is not without risks. Analysts have expressed concerns about persistent NAV erosion and the sustainability of dividends, especially in a declining interest rate environment. The company's past dividend cuts and a recent downgrade to junk status by S&P and Moody's, partly due to rising payment-in-kind (PIK) interest, highlight these challenges. While management has strongly refuted notions of a "crisis option" for preferred stock conversion, the perception of such risks can impact investor sentiment. The Q1 2026 outlook, with $161 million in originations (92% middle-market lending) against $253 million in repayments, resulting in $92 million of net repayments, indicates a period of portfolio adjustment rather than aggressive growth.

In conclusion, Prospect Capital Corporation is actively transforming its business model, shedding non-core assets to become a more focused and resilient first-lien middle-market lender. This strategic reinvention, underpinned by a disciplined investment platform and a robust capital structure, aims to deliver more stable and attractive risk-adjusted returns. While the company faces scrutiny regarding past performance and market perceptions, its commitment to a conservative leverage profile, diversified funding, and a targeted lending strategy in the less competitive lower middle-market positions it for potential long-term value creation. Investors should closely monitor the execution of this strategic pivot, particularly the successful redeployment of capital and the sustained improvement in net investment income and non-accrual rates, as these will be critical indicators of its ability to deliver on its promise of a stronger, more focused future.