5 Reasons Prospect Capital Is Buying Another Subprime Lender

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Prospect Capital is on an acquisition spree. Last week, it nearly doubled its investment in apartment buildings. This week, it announced a $326 million acquisition of Nicholas Financial , a subprime automotive lender.

This isn't Prospect Capital's first rodeo. Nicholas Financial will join First Tower and Nationwide Acceptance as a wholly owned portfolio company.

Here are five reasons I think Prospect Capital wants Nicholas Financial.

1. Operating synergies
Prospect Capital's Nationwide Acceptance currently writes automotive loans in 12 of the 15 states in which Nicholas Financial does business. As a wholly owned company, Nicholas Financial could potentially be paired with Nationwide Acceptance to divide and conquer their existing markets.

2. Financial synergies
Nicholas Financial's last reported cost of funds was 4.5%. When Prospect Capital took control of First Tower, it did so with a line of credit priced at 3.75% from Wells Fargo and Bank of America. Wells Fargo and Bank of America are back in the lineup on this deal, and if Prospect Capital can get similar terms, it will have already cut at least one big expense at Nicholas Financial.

3. Adios, taxes
Nicholas Financial has consistently paid more than 38% of its net income in taxes. Once it becomes a portfolio company of Prospect Capital, it will no longer pay a dime in income taxes. Given that Prospect Capital acquired Nicholas Financial at a 10% earnings yield (P/E of 10), its earnings yield as a portfolio company would be more like 16% (pre-tax P/E of 6). Avoiding income taxes is, by far, a BDC's biggest advantage in taking companies private.

4. Securitizations, maybe?
On its fiscal third-quarter conference call, Prospect COO Grier Eliasek commented about potential securitization in consumer lending. That is, wrapping up a number of automotive or personal loans and selling them to investors as a package. While the market for subprime, securitized automotive loans is, by all comparisons, virtually nonexistent, Prospect Capital's balance sheet of subprime loans will grow substantially with Nicholas Financial on the roster.

Prospect Capital has three giant subprime-originating machines in First Tower, Nationwide Acceptance, and Nicholas Financial. If it can securitize its loans, it can turn focus to originating loans and earn high returns on its investments while shifting risks off its own balance sheet.

5. A bubbly middle-market
Prospect Capital uses its "30% bucket" aggressively. By law, at least 70% of assets must be "qualified" for BDCs to enjoy tax-free status. Nicholas Financial, being a wholly owned financial company, isn't a qualified asset. Neither are First Tower nor Nationwide Financial.

With Prospect Capital investing so heavily in its non-qualified bucket, I'm led to believe Prospect Capital isn't as interested in middle-market lending. Returns have dropped, credit quality standards are easing, and it's especially competitive as more investors chase yield. Thus, acquiring operating companies is, for Prospect, a better alternative than putting money to work in other people's buyouts.

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The article 5 Reasons Prospect Capital Is Buying Another Subprime Lender originally appeared on Fool.com.

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America and Wells Fargo. 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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