Prospect Capital Earnings: 3 Things to Watch

Prospect Capital (NASDAQ: PSEC  ) will report earnings on Nov. 4, which is when we'll get another look into its growing number of portfolio companies.

And although Prospect Capital has a number of moving parts -- investments in 124 businesses, to be exact -- my focus will be on the following three earnings drivers.

1. First Tower
First Tower is Prospect Capital's biggest investment, valued at $288 million at the end of the last quarter. Naturally, the consumer finance company is also one of its biggest contributors to earnings; Prospect Capital has a debt position of $244.7 million, on which it earns an earth-shattering 20% yield, along with a major equity stake, which it reported to be worth $20.4 million.

What makes First Tower interesting is how it is capitalized. Prospect has levered it with debt, which makes the equity only a small component of its total valuation. I'll be focused primarily on the equity position, since its movements -- up and down -- will indicate whether it's keeping up with Prospect's expectations.

Last quarter, Prospect Capital wrote down the equity stake by $9.9 million on slower loan growth. Prospect Capital management has previously indicated that this is a seasonal business that typically picks up in the fourth quarter, so some optimism about loan volumes in the busy holiday season would be reassuring.

2. CLO investments
Perhaps the most opaque of all its investments, Prospect Capital has a hefty investment in collateralized loan obligations equal to one-sixth of all debt securities. These investments pay off handsomely when the underlying loans perform well, but all it takes is a minute change in credit quality for CLO investments to take a large impairment.

Luckily, we're in the midst of the best part of the credit cycle, where cash flows like water and the bills get paid. But with so much of Prospect Capital's assets tied up in CLOs, investors will want to double-check its collateralized loan obligations for any impairment.

Remember, Prospect Capital owns the "residual interest" in the CLOs in its portfolio. The residual interest is the last in line to be paid, and the first to be cut off if the underlying investments perform poorly. That's why it earns so darn much -- returns are in the "high teens" -- on its CLOs.

3. Asset mix
While not technically an earnings driver, the company's asset mix between first-lien, second-lien, and senior or subordinated debt is as important now as it's ever been. At most industry conferences and in recent data the market is growing more comfortable with more leverage on middle-market companies. Likewise, financiers are issuing more covenant-light loans, which provide less protection to creditors.

First-lien secured debt simply isn't as safe as it used to be. Thus, investors should question very carefully the balance of portfolio investments. Ideally, Prospect Capital will continue to write high-quality loans in a first-lien position to protect investors from the greatest losses.

First-lien debt is the first debt to be paid in the event of a default, so this will be of particular interest when Prospect Capital announces earnings next week.

The Foolish takeaway
Business development companies are complex by design. However, investors who carefully watch what moves the needle at any given BDC can stay on top of a company's performance. I'll be looking at the performance of First Tower, the CLO investments, and investigating Prospect Capital's asset mix when earnings are released.

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