Better Buy Now: Prospect Capital vs. Main Street Capital

Here's how I would compare two top performing business development companies.

Jan 10, 2014 at 4:46PM

My Foolish colleagues David and Matt recently received this question on their show Where the Money Is:

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Mike, this is a great question. Prospect Capital (NASDAQ:PSEC) and Main Street Capital (NYSE:MAIN) are two of the best performing business development companies on the market today. Let's go line by line, and I'll explain how I'd approach this investing dilemma.

From the bottom up
Prospect Capital's fundamentals look great. The company has managed to increase dividends to shareholders and avoid serious capital losses in the six years since the financial crisis. In fact, not a single loan issued in the last six years by Prospect Capital is currently on non-accrual (underperforming).

With that said, Prospect Capital is vastly different than Main Street Capital. First, its portfolio is arguably higher risk. Prospect Capital is heavily invested in subprime consumer lending, which has regulatory risks and collateralized debt obligations, which are essentially super-leveraged loan portfolios. This is how Prospect Capital is able to pay a big 11.9% annual dividend.

Second, Prospect Capital is growing very, very quickly. In September 2011, Prospect Capital reported $1.7 billion in assets. Just two years later, that figure is up to nearly $4.8 billion. Including acquisitions following the recent quarter, assets will easily top $5 billion. Fast-growing financial companies can be worrisome, because defaults typically happen as loans age. So fast growth can "paper over" problems now and in the future.

The company's recent foray into real estate is no immediate reason for concern. Prospect Capital is a very opportunistic investor. The management team will go anywhere for returns and, in this case, Prospect Capital had an opportunity to buy real estate with favorable financing from Fannie Mae and Freddie Mac. Management seems happy with the potential for rising rental income and capital gains. Of course, this is a new venture -- it's still too early to tell.

How these BDCs stack up
I don't think investors should sell Prospect Capital, but I do think diversification helps. If I were in a similar situation, I would consider adding Main Street Capital alongside my holdings in Prospect Capital. And here's why: Main Street Capital is an equally good operator and lender, and it has a much better cost structure.

Prospect Capital is externally managed, so investors pay fees equal to 2% of assets and 20% of returns each year just for holding the company's shares. Main Street Capital is internally managed, meaning it pays its employees directly. As such, Main Street Capital shareholders enjoy much lower costs for holding its shares. Total costs come in at about 1.7% of assets annually at Main Street Capital, significantly lower than Prospect Capital's cost of ownership.

While Main Street Capital's higher share price at 1.7 times book value might not be immediately appealing, over time, its lower cost structure should bode well for shareholders. The premium you pay for its shares will fall over time as lower costs play out.

Finally, I think Main Street Capital does a better job of aligning management with shareholders. Managers aren't paid for growing the asset base -- their salaries follow investment returns. And, most importantly, insiders own more than 7% of all shares outstanding.

I personally wouldn't take the time, or costs (especially a tax hit!), to move from Prospect Capital to Main Street Capital. Rather, I'd just build a new position in Main Street Capital.

For investors who think in terms of years, not months, Main Street Capital's lower costs help justify the higher price and lower dividend. All else being equal, lower costs mean that Main Street Capital can generate similar returns as Prospect Capital with less risk.

When it comes to "jockey plays," where you essentially bet on the manager's ability, I like the fact that Main Street Capital managers own a significant part of the equity -- more than $0.07 of every dollar invested by Main Street Capital is owned by an insider. You want managers to invest your money as if it was their own. At Main Street Capital, a greater percentage of each dollar invested is the management's money.

All things considered, it's my opinion that Main Street Capital is a better buy now for someone who owns another BDC. I like the fact that you can get another income-producing stock while diversifying into a new name. Consider it a two-for-one special. 

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Fool contributor 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.

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