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The business development companies ((BDCs)) continue to garner more investor attention as the access to a different investment class and high yields become ever more attractive. After highlighting Prospect Capital Corporation (PSEC) a few weeks back, Fifth Street Finance Corp. (FSC) now garners our attention with a yield above 10%.

Fifth Street Finance is a specialty finance company that lends to and invests in small and mid-sized companies in connection with investments by private equity sponsors. The company provides full debt structure financing solutions including: first lien, second lien, mezzanine, and one-stop. It trades as a closed-end investment company that has elected to be treated as a business development company (BDC) under the Investment Company Act of 1940.

Though the company that went public in 2008 has historically not grown Net Asset Value (NAV), Fifth Street recently reported record transaction volumes for the December quarter.

Quarterly Record Transactions

Ultimately an investment in the BDC firms has to do with the quality of the transactions the company secures. The company had origination records of more than $422M in Q4. These numbers were partially aided by additional capital raised during September and December via public stock offerings. In fact, the September offering of $91M was deployed via a record $120M of gross originations in October.

The company along with the general sector benefited from a desire for small company owners to cash-out prior to the expected higher tax rates for 2013. Investors will be intrigued to see the details on the debt investment yields obtained on these transactions. Obtaining deals is not always the same as obtaining deals at attractive prices. At the end of Q3, the company had an average yield of 12% on debt investments. This compared favorably to the recent syndicated credit facility at LIBOR + 275 basis points.

As of the end of Q3, the top 10 investments accounted for 29% of the investment portfolio. The list includes Welocalize, Statewide Holdings, Tegra Medical, InvestRx Corporations, and Yeti Acquisition that each equal over $40M of investments. An investment in Fifth Street will largely be impacted by the results of these major investments.

(click to enlarge)

Dividend History

The dividend history is crucial when understanding the investment rationale for this sector. Knowing how a stock that makes investments in middle market companies navigated the Great Recession helps understand the potential risk in this investment.

Fifth Street management has done the stock no favor, as the net investment income hasn't covered the dividend with NII at only $0.95 in 2010. The company expects to finally cover the dividend with NII in 2013, which questions why the company didn't right size the dividend in the past.

The company cut the monthly dividend from $0.1066 in the December quarter to $0.0958 for the January 2012 monthly dividend. The cut from an annual dividend of $1.28 to $1.15 was way past due. Prior to that the company consistently paid quarterly dividends for 2009 and 2010 in the $0.25 to $0.30 range.

The dividend should be appealing to investors looking for yield and especially the aspect of the monthly dividend. Though, Prospect offers a slightly higher yield and appears the better value at this point.

Stock Price

The stock remains below 2008 IPO levels and has failed to break above 2011 highs unlike most stocks in the sector. The company sold 16M shares at $10.68 in December and 8.5M shares at $10.79 in September, both above the NAV.

The following chart compares the stock and other BDCs over the last five years. American Capital (ACAS), Ares Capital (ARCC), Main Street Capital (MAIN), and Prospect Capital have all had better returns in that time period.

FSC Total Return Price Chart

FSC Total Return Price data by YCharts

Over that time period, Fifth Street has had a negative return when excluding dividends. The total return jumps to 42% when adding in those juicy dividends that have averaged nearly 10% a year over that time period.

Unfortunately, the stock sits at the bottom of the pack with Main Street and Ares Capital substantially outpacing the returns in the group.

Conclusion

Fifth Street Finance is a compelling stock that offers a consistent dividend yield in the 10% range. As mentioned in previous articles, American Capital provides a unique opportunity to purchase a BDC trading below NAV. Investors looking for yield instead should look no further than the consistently large payments from Prospect Capital. While the other BDCs provide solid and attractive dividends, Prospect has the highest offering at this point with Fifth Street close at over 10% and Main Street the lowest below 6%.

Fifth Street Finance went public right after the financial crisis had already hit making it difficult to see how the company would've survived the Great Recession. The stock has been consistent during that period, but the company has been unable to grow NAV or the dividend even as the crisis has ended. The stock can probably be avoided until the company can prove that the constant stock offerings actually add to NAV and NII.

Source: Fifth Street Finance Struggles To Grow NAV

Additional disclosure: Please consult your financial advisor before making any investment decisions.