The Dark Side of 20% Annual Returns

Earning 20% annual returns will put you squarely on the list of elite investment managers. It's no small feat to generate 20% annually when the S&P 500 has returned just 9.8% per year in the last 25 years, dividends reinvested.

So when a company like Prospect Capital (NASDAQ: PSEC  ) holds investments that are turning 20% annually, investors should pay closer attention. One of its portfolio companies, First Tower, a personal loan business, is doing just that -- paying Prospect Capital 20% per year on its debt investment.

What's this First Tower thing, anyway?
First Tower is, without question, the most important asset Prospect Capital has on its balance sheet. Making up more than 10% of net assets First Tower helps support Prospect Capital's generous 11.7% dividend yield. 

First Tower makes a lot of money. It loans funds to borrowers seeking small, short-term installment loans at interest rates topping 65% per year.

Obviously, these aren't the best of borrowers. But they aren't terrible credits, either. The profitability of the company shows that lending money at 65% or more is a terrific business, even if some loans are never repaid. At the last annual shareholders meeting, Prospect Capital management was sure to note that roughly 50% of its borrowers own their own home. These aren't payday loans.

But making high interest loans isn't a business model that escapes scrutiny. It settled charges for $340,000 in 1997 for violations of the Truth in Lending Act. I should note, though, that its settlement with the Federal Trade Commission happened before Prospect Capital bought a majority stake in the company.

In at least one state in which First Tower does business -- Missouri -- lawmakers have sought to cap interest rates at 36%. That bill failed. A new initiative is under way.

And headline risk is big with this one. Last month, one local Missouri news agency sat down with a disabled man who claims First Tower never made it clear that his loan would cost him 65% per year in interest. Of course, the jury is out on whether or not that claim is true. But KY3 News did report that workers at the state Attorney General office have heard complaints about Tower Loans.

A simple search of Tower Loans on Google will lead you to countless negative reviews mostly stemming from its collections processes. That kind of stuff draws undesired attention to a company that is making a mint from low-income borrowers.

It's not all ugly
The fact is that First Tower is profitable. And it is growing its loan book. I don't think anyone questions the reality that lending money at sky-high interest rates is a fantastically good business right now.

The question for Prospect Capital shareholders is whether or not a good regulatory environment can live on forever. If lawmakers crack down on high interest lending, it could have a big impact on Prospect Capital's bottom line, and its impressively high dividend. It's not the kind of thing that would send Prospect Capital into insolvency -- not even close -- but it would have a material impact on the balance sheet, and the company's earnings power.

Even with all the "ugly" parts of the business completely exposed, you should note that the company is compensated heavily for the risk. At the end of the day, it doesn't take many years of 20% returns to really knock the ball out of the park. If, for example, First Tower simply imploded 10 years from now, Prospect Capital shareholders could still be happy with the sky-high returns earned over the period.

And we should also remember that companies that don't pass muster for being "socially responsible" have been great investments in the past. For years, investors have believed tobacco stocks would eventually be crippled by sin taxes, regulations, and lawsuits. That thesis never played out, and investors who consistently reinvested the fat dividends from tobacco stocks made a killing.

That could be the case at Prospect Capital. Right now, First Tower is a tremendously profitable business. Will it go on forever? No one can say. Regulatory risk is so hard to predict. But it is worth noting that First Tower is one of the many reasons why shareholders demand such a large yield from Prospect Capital stock. Its biggest investment is one of the riskiest.

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Read/Post Comments (9) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 12, 2013, at 10:35 AM, Costanzawallet wrote:

    Profits like those are always made at the expense of others. It is wise for any investor to take a moment and think about what they are investing in, and if they want to be a part of that kind of investment. Some people don't care how they make their money, while others seek more responsible and ethical investments.

  • Report this Comment On November 12, 2013, at 11:01 AM, TMFValueMagnet wrote:


    Don't get me wrong, there's a reason these loans come with high rates: defaults are also very high.

    I just want to get the point across that First Tower does have some regulatory risk that can be hard, if not impossible, to predict.

  • Report this Comment On November 12, 2013, at 3:04 PM, paultaut wrote:

    I have owned Prospect for around 5 years with purchases ranging from about $8 to $10.

    In a few years it will have paid for itself.

    I don't care what they invest in as long as the Officers and Directors put their own assets at risk by buying the company's shares on the Open Market and holding onto them.

    Being retired and unsure as to what will happen with my SS and Medicare, having a steady source of external income is essential.

    Caveat, Insiders bail, I do also.

  • Report this Comment On November 12, 2013, at 4:52 PM, TMFValueMagnet wrote:


    Prospect Capital's managers do have about $40 million of "skin in the game," so to speak, and they've never sold a share, according to their own presentations.

    Management does have a lot of money in play. Whether or not it is a relatively large or small portion of their net worth or annual income is impossible to know, since Prospect Capital is externally managed. As with all BDCs, it's a bet on the jockey -- the managers.

    It's not that I agree or disagree that First Tower is a good risk, I just think investors should be informed of the potential risks to that kind of model, and how important First Tower is to Prospect Capital's balance sheet and dividend. Handicapping regulatory risk is a very hard thing to do.

    Thanks for sharing your perspective.


  • Report this Comment On November 12, 2013, at 7:43 PM, promommyfool wrote:

    Those high interest loan companies have their place in the world and they are not all bad guys. If you are a business owner and need to float a short term loan for inventory or supplies for a large contract, it may be worth it. I do know regular banks frown on short term loans. Thats why I liked the idea of investing in Prospect.

  • Report this Comment On November 13, 2013, at 10:01 AM, paultaut wrote:

    TMF try this site J3SG,com.

    Its a freebee I use to get ongoing emails on 25 stks I either own or folllow.

    You must subscribe (free sub) but you get up to 25 companies to peruse by setting up a porfolio and having updates emailed to you.

    Its strictly Officers, Directors (occasionally family members) and Beneficial owners of 10% or more but looking at a person will list other Major postions they hold.

  • Report this Comment On November 13, 2013, at 11:36 AM, TMFValueMagnet wrote:


    I agree. Short-term lending has a place. It's mostly an argument that has to be constantly won with regulators, consumer advocates, and state legislators.

    If you're a Missouri legislator who wants to make a name in state politics, fighting quasi-banking institutions is a great way to do it. That's a problem for lenders.

  • Report this Comment On November 13, 2013, at 11:38 AM, TMFValueMagnet wrote:


    Thanks for a very helpful link. I've been tracking those via SEC filings, but this is a much more user-friendly database.

    Unfortunately, it still won't tell us salaries, since the company that manages Prospect Capital isn't public.

  • Report this Comment On November 13, 2013, at 1:26 PM, GrampaRick wrote:

    To get more of a flavor of how PSEC invests, watch a video presentation when the management spoke to analysts back in July, 2013. It is 4 hours long but well worth watching & you can pause it from time to time.

    When I emailed PSEC to ask for a link, they responded the same day.

    Jordan Wathen presented a well written article.

    I've owned PSEC for a couple of years and reinvest the dividends into additional stock.

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