Earlier this week, I wrote an article about Prospect Capital's biggest asset: First Tower, a personal loan company.

I uncovered some of the reasons this asset is so central to the Prospect Capital thesis. First, it generates high, 20% annual returns. Second, it has some unique risks stemming from potential regulatory risks in the future.

Stress testing the idea
Before I ever make an investment, I like to identify the worst-case scenario -- what risks could blow up my investment.


The way I see it, if I can eliminate surprises to the downside, simply avoiding a worst-case scenario results in better-than-expected returns.

So let's "stress test" Prospect Capital for a regulatory event at First Tower. We'll assume the absolute worst case: Prospect Capital loses everything from a regulatory change. First Tower's loan book goes to zero, and the payments stop coming in.

Prospect Capital has three different First Tower assets:

  1. A loan to First Tower for $264.76 million at 20% interest.
     
  2. Common stock in First Tower of Delaware (which owns 80.1% of the operating loan company) worth $34.94 million.
     
  3. A royalty of sorts (net revenue interest) that pays Prospect Capital 5% of net revenue at First Tower, which it valued at just under $14 million.

All in all, Prospect has $313.67 million at stake, or about 10.7% of net asset value. So, if First Tower blew up tomorrow, Prospect Capital's reported first-quarter NAV of $10.72 per share would look more like $9.57 per share.

What about the dividend?
Simply carving out the NAV loss does little to explain the downside risk to Prospect Capital in the event First Tower takes a dive.

First Tower is a meaningful contributor to Prospect Capital's earnings and beefy 11.7% dividend yield. So we need to go back to the SEC filings to see how much First Tower contributes to Prospect Capital's top line.

The 20% interest loan of $264.7 million generates $52.94 million in annual interest income. The common stock has not paid a dividend to Prospect Capital, and it's not clear what funds are traveling through the net revenue interest. However, to be conservative, we'll take the "other income" of $699,000 reported in the last quarter from First Tower and add it to the prior year "other income" of $2.426 million to measure its full impact on income.

When we add it all together, we find that First Tower contributes $56.065 million to Prospect Capital's top line.

How this "stress test" affects income and dividends
We're in the final stretch. At $56.065 million per year, First Tower contributes an average of $14 million to Prospect Capital quarterly.

Now we adjust for management fees. Prospect's external manager earns about $1.5 million in quarterly management fees that can be attributed to First Tower. It also takes another 20% of income in incentive fees, which is another $2.5 million.

In total, First Tower adds about $10 million of net income on a run rate. Given this quarter's net investment income of $82.3 million, we can conclude that First Tower makes up about 12% of Prospect Capital's total income. First Tower also makes up about 12.5% of dividends paid ($80 million in the recent quarter).

The Foolish bottom line
In the worst-case scenario, an absolute blowup of First Tower would result in a 10.7% haircut to Prospect Capital's net asset value. If dividends were cut accordingly, Prospect Capital's $0.11 dividend would fall to about $0.096 per share. The dividend yield at today's price would be right at 10% per year, down from 11.7% currently.

Investors should keep things in perspective. First, a complete and total loss at First Tower is unlikely as it operates in five states and payments wouldn't likely stop immediately. And even if they did, First Tower would still be the highest-yielding BDC.

However, it's also important to keep in mind that we're talking about a single solitary investment out of 129 portfolio companies. First Tower is much larger than the average, so it still deserves astute attention from investors. I know I won't keep my eyes off it -- it's just too big to ignore. 

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The article Prospect Capital: The Dark Side's Downside originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned, and neither does The Motley Fool. 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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