Bad Loans Come Back to Bite Prospect Capital Corporation

Photo: Erich Ferdinand

Lending is a game of risk management -- a careful balance of risk and reward. 

For some, the stakes are higher than others.

Ares Capital Corporation (NASDAQ: ARCC  ) and Prospect Capital Corporation (NASDAQ: PSEC  ) are two such lenders that have to be particularly careful underwriters. Because these giants make cash flow loans (loans to businesses with little or no tangible collateral), bad loans can result in a total loss of capital.

Thus, even though their loans may offer yields of 10% or more per year, one loan loss can erase the profits from ten performing loans in any given year.

Testing for underwriting quality
One of the best ways to test a lender's underwriting ability is to look backward. While the future is not guaranteed to look like the past, the truth is that underwriting cultures develop in any company. Good underwriters tend to stay good underwriters. Bad underwriters tend to stay bad underwriters. There are any number of reasons for this -- compensation methods or corporate culture -- but it's observable in everything from banking to insurance.

With fresh financials in hand, I went back to compare Ares Capital Corporation and Prospect Capital Corporation's historical underwriting record. I looked at each company's historical net realized gains or losses, and compared them to year-end assets.

Net realized gains or losses are income (positive or negative) generated from the sale of assets above or below cost. Selling a $10 million loan for $11 million would result in a $1 million realized gain. Likewise, selling a $10 million loan for $9 million would result in a $1 million realized loss. I prefer realized gains as a measuring stick because it reflects gains or losses stemming from an actual sale or liquidation of an asset, validating the valuation at the time.

Here are the results comparing Prospect Capital and Ares Capital over time:

At first glance, you'll realize it's no contest. Prospect Capital Corporation has had significantly more realized losses, particularly during the financial crisis, when realized losses topped 6% of total assets. Ares Capital Corporation, however, posted realized losses in only one year -- 2009 -- and realized gains in every other fiscal year.

These two make for an interesting comparison because they are very similar. Both are externally managed. Both went public at roughly the same time. Both acquired another external portfolio during the financial crisis. (Prospect Capital acquired Patriot Capital; Ares Capital swallowed Allied Capital.) Finally, they are routinely in top four BDCs by assets and market capitalization.

Not surprisingly, underwriting quality has an impact on total stock returns. The chart below shows the total return price of Ares Capital and Prospect Capital over the last 10 years, which takes in consideration the impact of dividends received over the period:

ARCC Total Return Price Chart

Looking ahead
If there's one important takeaway here, it's that dividends alone are not a good measuring stick for a company's total return. Losses or gains add or subtract from book value, and over time, they have an outsized impact on a company's performance through economic cycles.

While the past is the past, it is probably safe to say Ares Capital Corporation has a much better underwriting process than its peers. Whether or not you want to let a company's history project the future is up to you. But the results don't lie: Ares' has been a much better underwriter than Prospect Capital.

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Read/Post Comments (5) | Recommend This Article (12)

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 May 13, 2014, at 2:02 PM, foolishfollies wrote:

    And yet PSEC is rated higher by the caps community. Why? Are your readers clueless? Please explain.

  • Report this Comment On May 13, 2014, at 5:06 PM, houston321 wrote:

    I find your timing of this article dubious as is your weak attempt at justifying you analysis;

    "One of the best ways to test a lender's underwriting ability is to look backward. While the future is not guaranteed to look like the past, the truth is that underwriting cultures develop in any company. Good underwriters tend to stay good underwriters. Bad underwriters tend to stay bad underwriters"

    And tell us, Mr. Wathen, just which business management school taught you this gem of wisdom? Or perhaps you are just using the megaphone of TMF to spout one of your own personal opinions as to PSEC. This article has ZERO current validity as to PSEC's underwriting, it seems more to serve the purposes of someone with an ax to grind piling onto a company with fictitious bad news at a time when short sellers are attacking the shares for an entirely unrelated (to your underwriting) reason. You must know in the news business that many people only read headlines, and thus by penning a title containing the phrase "Bad Loans" and Prospect Capital, you succeed at deceiving so many less informed readers that now think the reasons PSEC is being taken to the woodshed are some fictitious "Bad Loans" which are currently creating havoc. Just one more article with a hint of bad news to pile onto PSEC with. Why not pen one that states "PSEC shares could decline if S&P goes into bear market"? Or "PSEC could cut dividend if Headquarters hit by meteor" or some other meaningless drivel. In my opinion you sir, are unethical at the least.

  • Report this Comment On May 14, 2014, at 8:36 AM, andrewboon2739 wrote:

    Interesting take on this situation, Banks need to have stronger supervisory action against loan loss and consistent with accounting standards afford to ease some loan requirements. I work for McGladrey and thought this conversation aligns well with a white paper that was created on this subject, if your readers are interested in it.@ “ The one constant in retail is change” https://bitly.com/1hrViqk

  • Report this Comment On May 14, 2014, at 12:27 PM, TMFValueMagnet wrote:

    Houston321,

    Realized and unrealized depreciation were responsible for $0.06 in negative movement in NAV this quarter. That's significant.

    This year alone, Ares Capital and Prospect Capital will likely reward their external managers with a combined $500 million in management fees. Is it wrong to ask what you're getting for all that money?

    If it's unethical to share a historical look at a company's underwriting, I'll continue to be unethical. I think it's important to run this simple test for virtually every BDC, investment company, or closed-end fund. I plan on doing it for every BDC out there. No harm in looking at the past, no?

  • Report this Comment On May 14, 2014, at 6:14 PM, awallejr wrote:

    "No harm in looking at the past, no?"

    Well actually there could be if you wind up drawing false conclusions for future action. That is one of the main reasons why I don't support most TA analysis.

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