Prospect Capital Corporation's Plan to Earn 23% Per Year

Source: www.planetofsuccess.com.

I have to tip my hat to Prospect Capital (NASDAQ: PSEC  ) -- it always has some unique, out-of-the-ordinary way to make a buck.

Recently it's been apartments. Now, it's a plan to get into the peer-to-peer lending space to earn as much as 23% per year.

Loans by individuals, for individuals
Peer-to-peer lending companies launched as a way for consumers to skip the bank. You can go online to one of many peer-to-peer sites (the biggest being Prosper and Lending Club) and ask for a loan. Then, investors, most of whom are individual investors, look at your loan request and decide whether they want to make you a deal.

From start to finish, hundreds of investors may make up just one loan. Once the loan is fully funded, Prosper and LendingClub send the cash to the borrower and process all the back-end stuff like making sure you pay on time and that the investors get their portion of the payments when each amortizing payment comes in.

The potential
Returns from LendingClub and Prosper vary greatly by credit quality. On the conference call, Grier Elisak said Prospect is getting a weighted average yield of roughly 13%. After expected losses, which Prospect believes will come in at 5% of the loan portfolio, the net return is 8%.

Obviously, for a double-digit yielder like Prospect Capital, an 8% return is much too low. Prospect Capital thinks it can leverage this portfolio up to 3-to-1 with secured funding.

We can run the numbers on what this portfolio might return based on its own projections. We can estimate that Prospect Capital would fund this with a line of credit with a rate consistent with its funding for its corporate line of credit as well as its funding for First Tower, another consumer loan company. Prospect can currently borrow at LIBOR plus 2.75%.

That puts Prospect Capital's funding costs at roughly 2.90% per year. That's cheap. Levered at 3-to-1, Prospect would earn 8% on assets and pay total funding costs equal to 2.175% of assets, for a total return on equity of 23.3% per year.

That's good for 18.2% annually after accounting for management fees.

That's the expectation. What about reality?
Everything in the conference call is consistent with data from one P2P lending site, Prosper.com. Prospect said it was looking at borrowers with FICOs of 700 or better scores and expected 13% returns with losses in the 5% range.

I did my digging. Prosper.com has a page outlining returns for various loans by credit quality. The B-range borrowers have a 700-plus credit score, tend to yield about 14% per year, and have losses at around 5% per year.

There is one important caveat: This is looking at Prosper's historical returns since the middle of 2009. As we know, that's when the economy started improving.

Prosper has changed its pricing model and leadership team since the pre-crisis era, but the company discloses that loans between November 2005 and June 2009 produced a negative-5.29% return. LendingClub reveals that loans issued in 2007 and 2008 to B-credit borrowers returned roughly 3.2% per year.

The Foolish bottom line
Prospect Capital's P2P lending is interesting, but it's not exactly compelling. Prospect Capital earns huge returns in its other consumer lending businesses because it adds value by finding the customers. That's the hard part of consumer lending. The easy part is providing the capital to do it. P2P lending sites take out the component that adds value (finding borrowers), and the investors provide the commodity -- money.

If Prospect Capital proves to be profitable in P2P loans, other financiers, who have much lower-cost capital, can do exactly the same thing. Investors should probably look at this as a niche, and potentially temporary, place for Prospect to earn a return.

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