Just when you thought Prospect Capital (NASDAQ:PSEC) had plenty of consumer finance exposure, think again.
Recently, Prospect Capital refinanced a debt investment in one of its portfolio companies, Progrexion, a consumer credit repair company, increasing its stake to nearly 7% of assets under management.
Most wouldn't recognize the name, but many in the consumer finance space know one of its operating brands: Lexington Law. It's a credit repair company that works with consumers to clean up errors and negative marks on consumer credit reports in exchange for a monthly fee.
Credit reports are full of errors. An FTC study suggests as many as 5% of consumers had errors so significant that it would lead to higher rates on insurance products, car loans, and mortgages.
Lexington Law disputes inaccurate and negative entries on its customers' credit reports. If the creditor cannot verify the accuracy of the claim, and provide evidence that negative marks are warranted, they are promptly removed. In exchange for these services, Lexington Law charges $99.95 for the first month of service, plus $59.95 thereafter. More expensive plans provide an even greater level of service.
A commodity business
Lexington Law doesn't have any particularly strong competitive advantages. In fact, its customers can make use of its methodologies on their own time, and for free. Thus, its biggest advantage, if anything, is that consumers lack knowledge of credit reporting, and the time to dispute inaccurate entries on their own.
But what the company does have is growth. Following the 2008 financial crisis, many consumers found themselves on the wrong side of a financial reality check. Now, with the economy recovering, they're finding that tougher underwriting standards prohibit them from basic financial resources like car loans and mortgages.
This is where Progrexion fits in. A note from Moody's explains that the company is leveraged as high as 7 times EBITDA, which could drop to 5.5-6.5 times EBITDA in the "next one to two years." This suggests EBITDA growth is in the range of 10%-20% per year. Moody's does warn, however, that the business requires a continuous supply of new customers, since its customers need its services for only a few months. This isn't an ongoing subscription model.
Prospect Capital's involvement
Prospect Capital has increasingly loaned more and more money to Progrexion. As of March 31, Prospect Capital held a $437.8 million investment in the form of a senior secured loan. This is up substantially from $241 million as of June 2013, and $62.68 million as of June 2012.
Why is Progrexion so busy borrowing more and more money? The short answer is to reward its private equity sponsors, who have refinanced existing debt and added new debt for dividend recapitalizations. Dividend recaps involve using borrowed money to pay a dividend to the company's owner.
This kind of lending is risky, no doubt. Dividend recapitalizations require a firm to support a larger amount of debt at the same time cash is removed from the business. However, from Prospect Capital's angle, such a maneuver allows Prospect to invest more money into a business with which it is already familiar.
Prospect is becoming a consumer finance machine
Love it or hate it, Prospect Capital is becoming more and more involved in consumer and business finance. The company has a slew of operating finance companies, from First Tower (personal loans) to Nationwide Acceptance (subprime automotive finance) to Harbortouch (a payment processor and merchant financier).
Progrexion is sizable, and worthy of additional attention from investors. At the end of the March quarter, loans to Progrexion made up roughly 7% of Prospect Capital's total balance sheet. When combined with other consumer finance companies (and ignoring Harbortouch), Prospect Capital's total investment in the industry is equal to about 14% of its entire asset base.
Given its increased commitment, investors should pay close attention to how this company performs going forward, since any problem -- late payments, non-accrual, or default -- would lead to a significant loss for shareholders. For now, though, it's safe to say Prospect Capital shareholders are enjoying the 10.5% cash interest Progrexion pays on its existing loan from Prospect.
Jordan Wathen 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.