The Dark Side of 20% Annual Returns

Earning 20% annual returns will put you squarely on the list of elite investment managers. It's no small feat to generate 20% annually when the S&P 500 has returned just 9.8% per year in the last 25 years, dividends reinvested.

So when a company like Prospect Capital holds investments that are turning 20% annually, investors should pay closer attention. One of its portfolio companies, First Tower, a personal loan business, is doing just that -- paying Prospect Capital 20% per year on its debt investment.

What's this First Tower thing, anyway?
First Tower is, without question, the most important asset Prospect Capital has on its balance sheet. Making up more than 10% of net assets First Tower helps support Prospect Capital's generous 11.7% dividend yield.

First Tower makes a lot of money. It loans funds to borrowers seeking small, short-term installment loans at interest rates topping 65% per year.

Obviously, these aren't the best of borrowers. But they aren't terrible credits, either. The profitability of the company shows that lending money at 65% or more is a terrific business, even if some loans are never repaid. At the last annual shareholders meeting, Prospect Capital management was sure to note that roughly 50% of its borrowers own their own home. These aren't payday loans.

But making high interest loans isn't a business model that escapes scrutiny. It settled charges for $340,000 in 1997 for violations of the Truth in Lending Act. I should note, though, that its settlement with the Federal Trade Commission happened before Prospect Capital bought a majority stake in the company.

In at least one state in which First Tower does business -- Missouri -- lawmakers have sought to cap interest rates at 36%. That bill failed. A new initiative is under way.

And headline risk is big with this one. Last month, one local Missouri news agency sat down with a disabled man who claims First Tower never made it clear that his loan would cost him 65% per year in interest. Of course, the jury is out on whether or not that claim is true. But KY3 News did report that workers at the state Attorney General office have heard complaints about Tower Loans.

A simple search of Tower Loans on Google will lead you to countless negative reviews mostly stemming from its collections processes. That kind of stuff draws undesired attention to a company that is making a mint from low-income borrowers.

It's not all ugly
The fact is that First Tower is profitable. And it is growing its loan book. I don't think anyone questions the reality that lending money at sky-high interest rates is a fantastically good business right now.

The question for Prospect Capital shareholders is whether or not a good regulatory environment can live on forever. If lawmakers crack down on high interest lending, it could have a big impact on Prospect Capital's bottom line, and its impressively high dividend. It's not the kind of thing that would send Prospect Capital into insolvency -- not even close -- but it would have a material impact on the balance sheet, and the company's earnings power.

Even with all the "ugly" parts of the business completely exposed, you should note that the company is compensated heavily for the risk. At the end of the day, it doesn't take many years of 20% returns to really knock the ball out of the park. If, for example, First Tower simply imploded 10 years from now, Prospect Capital shareholders could still be happy with the sky-high returns earned over the period.

And we should also remember that companies that don't pass muster for being "socially responsible" have been great investments in the past. For years, investors have believed tobacco stocks would eventually be crippled by sin taxes, regulations, and lawsuits. That thesis never played out, and investors who consistently reinvested the fat dividends from tobacco stocks made a killing.

That could be the case at Prospect Capital. Right now, First Tower is a tremendously profitable business. Will it go on forever? No one can say. Regulatory risk is so hard to predict. But it is worth noting that First Tower is one of the many reasons why shareholders demand such a large yield from Prospect Capital stock. Its biggest investment is one of the riskiest.

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The article The Dark Side of 20% Annual Returns originally appeared on Fool.com.

Fool contributor 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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