Better Buy Now: Prospect Capital vs. Main Street Capital

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

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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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 January 12, 2014, at 9:11 PM, Argyll12 wrote:

    Why did you not mention the big difference in dividends? PSEC's dividend is twice MAIN's.

  • Report this Comment On January 13, 2014, at 10:04 AM, mike57dk wrote:

    Good am ...I used to own PSEC but switched to MAIN years ago ...primarily because of PSEC management's alarming tendency to dilute the share price ...over and over and over again with secondary offerings ...Every time the market price reached $14-$15 ..they would "punish" the shareholders with a new dilution ...

    Example - Share price of PSEC on Mar 2, 2009 - $6.58 and was $11.23 this am

    Share price of MAIN on Mar 2, 2009 - $9.70 and was trading this am at $34.03 ...

    As Argyll12 points out ...the PSEC dividend yield is twice that of MAIN ...but the price you pay for the constant dilution is severe.

    One last point ...while certainly "annoyed" by PSEC management and the numerous secondary offerings ...I also became concerned about their judgment ...One of their big losses back in 2010 was an investment in so called "green energy" in New England ...turned out to be firewood ...yes a firewood operation that collapsed and failed almost immediately ... while not inconsequential..it didn't ruin the earnings for the year ...but it did betray the hubris of PSEC management and the tremendous speed they were moving at ...calling a firewood operation "green energy" was the last straw so to speak ...They were going fast & furious ...and they did not give a damm about the shareholder ..whereas ...MAIN seems to be more prudent ...perhaps because of that 7% ownership.

    Thx -

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