Bad Loans

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:

Psec Vs Arcc

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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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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