INTRODUCTION

Fifth Street Finance‘s (FSC) stock price has been moving sharply up and down throughout 2017, and especially in the weeks after the BDC’s just-arrived CEO resigned. That happened in April. In May the Investment Advisor of FSC – Fifth Street Asset Management (FSAM) – put itself up for sale. In June, the Wall Street Journal leaked a story that FSAM was being acquired by Oaktree Capital. In July we discovered Oaktree was buying the investment management contracts of FSC and sister BDC Fifth Street Senior Floating Rate (FSFR). Now the participants and investors expect a closing of the acquisition by the IVQ of 2017. FSC began the year peaking at a price of $5.67 in January; dropping to $4.31 when the new CEO announced a large number of non-accruing loans and a reduction in distributions in February, and a new low of $3.92 just before the Wall Street Journal leak. Since then FSC jumped to just over $5.0 until the July 14 confirmation of the Oaktree transaction, which then took the stock price to a high of $5.71 on July 18.  From lowest to highest, FSC has moved 45% in a few weeks, and is now trading back close to its YTD high, and at a level achieved before all the developments mentioned above even occurred.

Furthermore, a number of analysts and investors believe FSC’s stock price has further to run, thanks to the imminent arrival of Oaktree Capital as Investment Advisor. On July 18, Deutsche Bank rated FSC a “Buy” with a target price of $6.0. National Securities went further and set a $7.0 Target Price. At time of writing FSC opened at $5.65 on July 19.

The BDC Reporter is always on the look-out for investment situations where reasonable persons may differ because of uncertainties about future outcomes. When all the relevant news is known to one and all, and there is general agreement the stock price reflects the consensus, and no opportunity exists. In the case of FSC there are many unresolved business issues and, as we’ll see considerable differences of opinion about how the BDC’s fortunes will play out in the quarters ahead. Of course, we track developments at FSC assiduously and periodically review the public information. However, we decided to take a “deeper dive” into the latest 10-Q, as well as prior quarterly filings we’ve annotated previously, to see what we could find. As the following article will suggest, the BDC Reporter has serious concerns about likely earnings through the remainder of FSAM’s tenure as Investment Advisor, and the lasting impact on the BDC even after Oaktree Capital takes charge in late 2017 or early 2018.

GOING BY THE NUMBERS

We begin with the latest 10-Q filing for the quarter ended March 31, 2017 and which was reviewed on a Conference Call by FSC’s new CEO on May 10, when the news of FSAM’s potential sale had already been revealed. FSC didn’t take any questions and investors may have been distracted by all the extraneous developments underway.  We took a fresh look at the results and what little was said (and unsaid) on the Conference Call, with a view to determining the relative financial health of the BDC at that time, and what that might tell us about the results in the quarters ahead.

On the face, the numbers are straightforward enough.  Net Investment Income Per Share $0.13 ($0.52 annualized) and the June quarterly distribution temporarily set at $0.02 but the IIIQ pay-out already fixed at $0.125 or an annual rate of $0.50.  Notwithstanding major Realized Losses booked in the quarter ($116mn or 6x Net Investment Income – to give a sense of proportion) Net Asset Value Per Share was at $7.23, only marginally down from $7.31 three months prior.

PROGRESSING ?

Management argued that “progress” had been made in the period. Here is a long extract from the Conference Call intro, which sets out their view:

 …At a high level, during the quarter, we stabilized credit, reduced leverage to within our targeted range, reduced the number of loans and percentage of the investment portfolio on non-accrual and instituted a total return hurdle. All of these actions should enable us to continue to generate more consistent results and deliver enhanced value for our stockholders going forward.

The March quarter was marked by greater credit stability a decrease in leverage to within our targeted range of 0.6 to 0.8 times debt to equity. As we continue to work through and resolve our underperforming investments, we believe that NAV has begun to stabilize. We ended the quarter with NAV of $7.23 per share, down $0.08 from the prior quarter. NAV was primarily impacted by one unrealized write-down of approximately $0.07 per share related to one equity investment. Excluding the unrealized equity investment write-down, our credit portfolio was flat quarter-over-quarter.

As we stated last quarter, one of our top priorities was resolving the assets on non-accrual and rotating those proceeds into traditional performing senior secured loans. During the quarter, we made progress executing on this initiative as we sold two investments that were on non-accrual and restructured two investments that were on non-accrual. As of March 31, we had eight investments on non-accrual, down from 11 investments in the previous quarter. Our non-accrual assets at March 31 represented 5.4% of total debt investments at fair value and 11.3% at cost, down from 7.3% of total investments at fair value and 18.2% at cost as of December 31.

WHAT LIES BENEATH

However, our analysis suggests that beneath the surface a series of changes were occurring at FSC – most of which were not discussed on the Conference Call – which could well result in materially lower earnings and NAV in the quarters ahead before Oaktree can do anything. Even after the new Investment Advisor comes on board, “fixing” FSC – largely due to the actions the current Investment Advisor has taken – will not be so easily achieved, as we’ll explain.

Let’s start, though, with what we found in the 10-Q:

1.The SBIC subsidiaries appear to being wound down:  Like many BDCs, FSC has two SBIC subsidiaries. At the end of 2016 the BDC had $213mn in debenture borrowings from the SBA, and $112mn in regulatory capital invested in its two subsidiaries. In the first quarter of 2017 FSC repaid $65mn of the SBIC debt outstanding, or 31%. This debt cannot be redrawn and was priced at a very advantageous rate.

We surmise that – as every 10-Q always reminds us – that “SBA regulations…include restrictions on a ‘change of control’ or transfer of an SBIC”. As a result, we believe FSC is in the process of winding down its SBIC subsidiaries in anticipation of the change of Investment Advisor. If we’re right – and we could be wrong – that would mean FSC will be either selling off portfolio companies in the SBIC subsidiary or will be – at the very least – deploying cash generated elsewhere to repay the remaining $146mn in SBA debt.

The impact will be (8%-12%) of portfolio asset decrease , and the associated income which yields roughly 10.0%, or ($15mn-$22.5mn) in lower Investment Income, and all in a very short period.

The other impact, which will be more subtle, will be the loss of the ability to use SBIC debt – which does not count against regulatory minimum BDC asset coverage regulations- to leverage up the portfolio.

2. The portfolio is shrinking, and likely to shrink more: Aside from the SBIC assets, the “regular” FSC portfolio has been dropping, with the IQ 2017 assets at cost down (18%) versus 6 months before, and (13%) less than 3 months before.

That may be a deliberate policy by the Investment Advisor or the impact of FSC’s personnel being otherwise engaged and distracted. Unfortunately or otherwise, this is at a time when refinancing activity is at an all time high and repayments are coming in fast and furious. Oaktree may be glad to receive a shrinking FSC, with a view to rebuilding the BDC in its own image of what the portfolio should look like. Shareholders may be pleased that the BDC is less levered as a result.

However, the result is also that interest and fee income will be dropping fast if this process continues in the next couple of quarters. That seems very likely to occur. Another 15% drop in assets – assuming they’re all performing loans – would amount to nearly $300mn, and could reduce (and we’re including the SBIC assets in these pro-forma calculations) Investment Income by $6mn-$7mn a quarter. Last quarter Total Investment Income was $45.6mn. Very roughly speaking down at the bottom line -which is Net Investment Income – that could mean ($3mn-$3.5mn) , or a 15%-20% drop.

3. The JV appears to be in trouble. FSC has a JV with the Glick family dating back to May 2014. FSC has invested $143mn, more than a tenth of its capital in this vehicle which is intended to generate a superior return by using a high amount of leverage, but investing in the same sort of assets as on balance sheet. (More on that later and it’s not Good News).

However, the 10-Q suggests (but no one at FSC officially confirms) that the venture is having problems, and income generated therefrom is dropping. We note that total Senior secured loans have dropped from $324mn as of September 2016 (see page 52) to $288mn at December 2016 and $255mn in the IQ of 2017, a (21%) drop in 6 months.  We also note that total assets in the JV are essentially unchanged as cash builds up, presumably from asset sales. The number of borrowers has already dropped from 37  to 31 in 6 months.

What is happening ? We don’t know. Maybe the JV is being put into deep freeze until Oaktree takes over and resumes with the Glicks. Or preparations are being made for a liquidation by selling off the portfolio. Of course, how that plays out will matter in 2018 and beyond ?

What we know now is that the vehicle is earning FSC less and less income. After a restructuring that occurred at the 2016 year-end much of the income is now in PIK form and dividend income from excess earnings. The latter income was ZERO in the IQ of 2017 after being $1.1mn the year before and $0.6mn in the IVQ of 2016, and $2.8mn in the first 6 months of $2016.

In toto, FSC earned $2.5mn from the JV in the IQ of 2017, but $0.9mn was in PIK form and may or may not ever be collected. A year before total income was $4.1mn, all in cash. That’s ($1.6mn) down and (60%) down in cash terms.

Unfortunately, the JV – invested as it is in many companies that are also in the BDC’s regular portfolio- experienced a major reversal in the IQ of 2017 with a realized Loss of ($9.4mn). That essentially wiped out several quarters of investment income. (We’re presuming this loss is related to bankrupt Answers Corporation, which was part of the regular FSC Realized loss mentioned before).

Going forward – if the JV is being liquidated – the investment income will drop further once the senior lenders are paid off, putting $2.0-$2.5mn of quarterly Net Investment Income at risk.

4. The investment portfolio continues to be have numerous weak spots. Notwithstanding the big Realized Losses in the IQ of 2017, FSC has hardly cleaned out the Augean stables that are its portfolio. We rely on our own company-by-company assessment but also FSC’s own calculations. Let’s have a look at those latter numbers first (page 88):

According to FSC, $19.9mn of assets at FMV are in their Category 3. These are loans performing below expectations and which “may be out of compliance with debt covenants” and which FSC will stop accruing PIK interest on, if any is contracted for. Another $37.3mn are in the lowest credit category where “some loss of principal is expected”. Remember, too, that these numbers only relate to debt investments held. Preferred and common investments that might be headed downward are not included. (Another recent FSC policy).  The BDC admits to 8 different companies still on Non Accrual.

The BDC Credit Reporter’s review of under-performing companies is broader, and may be more skeptical. We count 11 under-performers with a fair market value well over $200mn. That’s assets equal to a fifth (seems appropriate !) of FSC’s total equity in harm’s way.

That number can sometimes sound worse than it is if composed principally of what we call Watch List or Corporate Credit Rating 3 credits where we don’t yet anticipate the chances of principal loss are greater than the chances of full recovery.

Unfortunately, in the case of FSC,  the most troubled companies – those on non accrual – have a fair market value of $113mn. We count 9 names (we’ve added to FSC’s own list My Alarm Center. We know from Saratoga Investment‘s recent earnings filings that the company is in trouble and being restructured). Of the remaining 8, all but one is either are being written down further in value in the quarter, or in unchanged or is new to our list. Not much reason to expect a miracle credit improvement there.

We are also keeping an eye on 2 other Corporate Credit Rating 3 companies, which could yet cause FSC difficulties. One is Ameritox Ltd., which was restructured last year (and is also owned in the JV) . FSC has $85mn in exposure there in debt and equity in the company. FSC has had to advance new monies to the troubled operator in the last quarter (not an encouraging sign), while writing down its equity valuation by three quarters (also worrying).   The BDC Reporter has long worried about how to evaluate portfolio companies which BDCs have taken over and control, and it’s hard to be anything but concerned about Ameritox and its $3.6mn in annual Investment Income and FMV of $61.6mn until we hear anything to the contrary.

Another question mark hangs over AdVenture Interactive, which is valued at cost of $44.2mn, but was just restructured and repriced. A quarter before that was a $90mn Term Loan which was valued at $47mn. Now FSC is lending $20mn in a new facility and values the new equity issued as part of the restructuring at $24.3mn.

We can’t say if FSC will lose any more income or NAV from this list of 11 (or several other names we’ve given the BDC the benefit of the doubt about) but the odds of running through the rain and not getting wet seem low. Nor can investors assume that if a company is on non-accrual – by way of FSC’s count – that more income cannot be lost. Many of the 8 names mentioned by FSC are on PIK non-accrual. If things went badly the cash income being derived could go on non-accrual as well.

5. Income and earnings include substantial non-cash items: FSC has always been somewhat aggressive in how some elements of income are booked. The 10-Q will show that the BDC books into income fees that may be due on the sale of a portfolio company (sometimes 5 or 7 years off) into income ratably across the life of the loans.

Now with an increasingly troubled portfolio a significant  portion of investment income is in Pay-In-Kind form, another non-cash measure. In the first half of the fiscal year PIK income was 6.5% of Total Investment Income and 15% of Net Investment Income. (No fees or expenses were paid in PIK form).

On a GAAP basis FSC earned $41.8mn in Net Investment Income in the first 6 months of its fiscal year. However take out PIK income and the non-cash accretion of original issue discount and cash income is 30% lower by our numbers, somewhere just under $30mn. Yet the dividend “liability” on a pro-forma basis is above $35mn.

We would argue that FSC is not even covering its $0.5 a share distribution from cash earnings in the first half of the fiscal year; less so in the last quarter and even less so in the quarters ahead, even if none of the issues we’ve discussed above are factored in.

WHAT ABOUT OAKTREE ?

We don’t know exactly what further losses FSC might incur before the handover to Oaktree, and what income might drop to. In both cases we expect the numbers to be materially lower than the IQ 2017 if only some the issues we discuss get in the way. We don’t believe – even on a GAAP rather than cash basis – FSC will be able to generate Net Investment Income sufficient to meet its $0.125 a quarter promised distribution.

NO CAVALRY

However, we can hear from our desk as we write this the optimists amongst you say:” What about Oaktree Capital ? Won’t they be able to “turn around” the portfolio and get the dividend back up” ?

We don’t think so – although we have nothing against the very clever folk at Oaktree who have many billions of dollars by their name.

The problem lies with the many troubles which FSAM will leave behind, which will keep Oaktree very busy and sometimes tie their hands.

These include:

1. The potential loss on the SBIC licenses and the need to re-apply, which might take several quarters to get approved.

2. The troubles at the JV, which may result in liquidation or much lower earnings than before. Starting again with the Glicks or a new partner will take several quarters to get going.

3. A long list of under-performing companies which will need to be sold or restructured in some way, a costly and time consuming process. This might require further write-offs and loss of income.

4. Repositioning an investment portfolio overly weighted to Healthcare and Technology. FSAM had a strong interest – their many credit losses notwithstanding – for those sectors. We looked at page 49 of the 10-Q and estimated that 50% of all portfolio assets fall under those two umbrellas. No wonder Patrick Dalton – the CEO with the shortest tenure in BDC history – called out that over-concentration in his only appearance on a FSC Conference Call and promised greater diversification. However, the selling down of these two sectors and the identification of new loans and industry segments will take multiple quarters.

5. High Cost Of Debt.  FSAM financed much of its portfolio growth with expensive Baby Bonds, in three different tranches. Currently, with the portfolio shrinking lower cost Revolver and SBIC debt is getting paid off while the expensive Baby Bonds remain, many of which are not accretive to earnings when interest expense, manager compensation, incremental operating costs and bad debt provisions are taken into account. What was good for the Investment Advisor Gander was not necessarily for the FSC shareholder Goose. Oaktree is going to have to develop and implement a new financing approach, which will take both time and money.

6. High Leverage: Oaktree – despite the recent shrinkage of the portfolio size – will have to contend with what is still a highly leveraged BDC, which limits growth opportunities. If we assume the net assets drop another $120mn to $900mn, and Oaktree limits leverage to 0.8: 1.00, the maximum total investment assets the new renamed FSC will have is $1.6bn. That’s already 10% off the IQ 2017 level, and we’re assuming maximum leverage.

7. Risk Profile Reduction: We’ve had early hints from Oaktree that reducing portfolio risk – and thereby yield – will be a goal under its tutelage. If Oaktree targets a portfolio yield of 8.0% to avoid some of the risks taken by FSAM investment income will be impacted. A $1.6bn portfolio earning a 1% lower investment yield results in 20% less Net Investment  Income than currently…

HOW LOW CAN WE GO ?

When we sharpen our pencils and make a few assumptions, this is what we get:

We assume a portfolio of $1.6bn with a 8.0% yield;  net assets of $900mn and leverage equal to 80%; Net Investment Income equal to 40% of Investment Income and a distribution policy of 90% of GAAP earnings.

That suggests FSC  (probably under its new title) will eventually pay a distribution as low as $0.32 a share versus a nominal $0.50 today. That’s a third lower.

If we’re right – and several quarters will be needed to get the subject in focus – it’s unlikely FSC will trade at $6 or $7 a share.

Even at a 12.5x multiple FSC will be worth $4.0. (An unlikely multiple of 15X would give a $4.8 price)

That $4.0 price is  30% lower than today’s price and nearly 60% off the most optimistic analyst price target.

INVESTMENT STRATEGY

To date we have taken no action. However, we have placed FSC on our Watch List to Short at a price north of $6.0 if market enthusiasm for the stock resumes in our Special Situations portfolio.

CONCLUSION/SUMMARY

• FSC’s stock price has rebounded sharply since the news of FSAM selling out to Oaktree Capital and target prices of $6.0 and $7.0 have been set by analysts.
• The BDC Reporter undertook a full blown analysis of the latest 10-Q filing and has a Bearish take on FSC’s earnings and distributions.
• Putting pressure on current earnings while FSAM remains in charge are paying off SBIC debt; trouble at the JV; overall portfolio shrinkage and continuing credit challenges and non-cash income.
• Even when Oaktree takes charge, FSC will face numerous challenges left over by FSAM which will negatively impact asset growth, earnings and the distribution for several quarters to come.
• The BDC Reporter estimates the distribution could be cut from $0.50 to $0.32 and the fair value price to $4.0-$4.8.
• We are preparing to “short” the stock if FSC’s stock price increases to $6.0 or above in our Special Situations portfolio