Prospect Capital Corporation's New $279 Million Money Machine

Photo: Harbortouch

This morning Prospect Capital (PSEC 0.74%) announced a $279 million deal to provide a debt and equity investment in Harbortouch Payments, a credit card processor.

This isn't your average transaction. First, it's sizable. At $279 million, it's equal to about 5% of Prospect Capital's total balance sheet.

Secondly, it may give way for Prospect to break into a very profitable lending segment -- merchant lending.

Loans one swipe at a time
Merchant lending is one of the fastest-growing small business financing categories in the United States. Small businesses turn to their merchant services provider for a loan. Over time, the loan is repaid based on a percentage of credit card sales.

The New York Times recently profiled one small business owner who used a merchant loan to fund his business. The Miami swimwear owner borrowed $200,000 for a fee of $55,000. The lender received 15% of the company's credit card sales until it was paid in full.

You'll notice that this isn't a traditional loan. It doesn't have an interest rate. Instead, the interest rate is completely variable, based on how long it takes for the small business to generate sufficient sales to repay the lender. In this case, though, the borrower ultimately paid an effective interest rate of more than 50%.

A Harbortouch pamphlet describes its typical loan. Borrowers receive an advance of $0.74 on the dollar, meaning a borrower would repay $13,513 for each $10,000 in principal. Because the loan is secured by future credit card sales, Harbortouch will lend to subprime borrowers, so long as the borrower has a credit score of 500 or better.

Prospecting for merchant profits
Harbortouch is hardly the only player in merchant lending. Ebay's (EBAY 0.18%) PayPal has ventured into the arena, offering small businesses the ability to borrow up to 8% of their annual sales with repayments based on their future PayPal volume.

Like merchant loans, PayPal's product also varies based on payment volume. PayPal takes 10-30% of its customers' daily PayPal transactions until the loan is repaid in full, plus a fee. PayPal's fees are variable, based on the revenue split PayPal receives from the borrower.

Source: PayPal

This is a competitive space, no doubt. But because it requires an existing relationship with the borrower (in the form of a merchant processing deal), it's less competitive than other forms of small business lending.

Doubling down
The co-investment between Prospect Capital and Harbortouch's founder will significantly increase Prospect's stake in the company. Prospect Capital's fourth quarter SEC filings show that it had invested just over $25 million in a term loan at a rate of 11.5%.

Now, Prospect Capital will become both a lender and equity owner, providing both first-lien secured loans and an equity investment. Given the stepped up relationship, and Prospect's foray into alternative financing of all flavors, it seems likely this is a play on Harbortouch's unique access to small business lending. It's an alluring business, one in which Prospect Capital should generate very attractive returns for its shareholders.