Fifth Street Finance's CEO Discusses F2Q13 Results - Earnings Call Transcript

| About: Fifth Street (FSC)

Fifth Street Finance Corp. (NYSE:FSC)

F2Q13 Earnings Call

May 9, 2013 11:00 am ET


Dean Choksi – Senior Vice President-Finance and Head-Investor Relations

Leonard M. Tannenbaum – Chairman and Chief Executive Officer

Bernie D. Berman – President, Secretary and Director

Alex Charles Frank – Chief Financial Officer


Robert Dodd – Raymond James

Greg Mason – KBW

Jonathan Bock – Wells Fargo Securities, LLC


Good day, ladies and gentlemen, and welcome to the Second Quarter of Fiscal 2013 Fifth Street Finance Corp. Earnings Conference Call. My name is Caroline, and I’ll be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, the call is being recorded for replay purposes.

And now I’d like to turn the call over to Dean Choksi. Please go ahead, sir?

Dean Choksi

Good morning, and welcome to Fifth Street Finance Corp’s fiscal second quarter 2013 earnings call. I’m Dean Choksi, Senior Vice President of Finance and Head of Investor Relations at Fifth Street. I’m joined this morning by Leonard Tannenbaum, Chief Executive Officer; Bernard Berman, President; and Alexander Frank, Chief Financial Officer.

Before I begin, I’d like to point out that this call is being recorded. Replay information is included in our April 16, 2013 press release, and is posted on our website, Please note that this call is property of Fifth Street Finance Corp. Any unauthorized rebroadcast of this call in any form is strictly prohibited.

Today’s conference call includes forward-looking statements and projections, and we ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. We do not undertake to update our forward-looking statements unless required by law. To obtain copies of our latest SEC filings, please visit our website or call Investor Relations at 914-286-6855.

The format for today’s call is as follows. Len will provide an overview of our results and outlook; Bernie will provide an update on our capital structure; Alex will summarize the financials and I’ll provide high level commentary on the BDC sector, then we will open the line for Q&A.

I will now turn the call over to our CEO, Len Tannenbaum.

Leonard M. Tannenbaum

Thank you, Dean. The supply/demand imbalance in the credit markets continued through the March quarter, putting pressure on loan prices and structures in the middle market. Credit markets are now benefiting from unprecedented levels of quantitative easing, which is forcing interest rates even lower, and pushing investors further out in the rest of risk spectrum into our search of yield.

The impact of quantitative easing and low interest rates give businesses, consumers and investors a sugar high, leading to more hiring by businesses, higher consumer spending and lower risk premiums.

The effects were positive, because it drove a rebounded of economy and asset prices after the financial crisis in 2008 and 2009, but the problem with the sugar high is it eventually ends.

So what can potentially bring them into this high? Will it be slower economic growth in China and Brazil, stagnant growth in Europe or the headwind space in the U.S. from higher taxes and lower government spending? Actually, I believe the answer is neither. I believe the frostiness is just beginning and that we are still in the early innings of the sugar high.

What should cause the sugar high to end eventually is the race among central banks to print money, which will eventually lead to a loss of confidence in a major global currency.

Fortunately, U.S. dollar remains relatively safe, given its status as a reserved currency for the world. Therefore, we believe the loss of confidence in the currency is likely to happen in one or more of the other countries aggressively printing. And that will be a sign of the sugar high coming to an end. The dynamic between lose monetary policy and slowing fundamentals should lead to greater volatility in asset prices as the capital markets climb.

In this environment, our strategy at Fifth Street is number one, prepare our balance sheet for rising interest rates by issuing long-term fixed rate debt and investing in floating rate assets; number two, continue to expand and reduce the cost of our secured and unsecured funding while maintaining excess investment capacity for opportunistic investments. And number three, taking appropriate risk to find pockets of opportunity in the market, where there is less competition and using our origination platform and capital structure to create competitive advantages.

Rather than pulling back from the market, we are taking advantage of opportunities. Our March quarter results reflect the strategy. We shifted our pipeline to include several larger deals where due to a larger hold size; we were able to maintain better structure and price relative to other segments in middle market. We were comfortable taking slightly more concentration risk as our portfolio became very diversified with our top 10 investments accounting for less than 30% of assets at the end of calendar year 2012.

The frost in the credit markets also led to higher repayments early in the quarter, as borrowers refinanced into lower cost loans, issuer from returns. As a result, we reported $0.28 per share in NII or net investment income, which was in line with consequences and flat with the prior quarters.

Sponsors are reacting positively to increased hold size. There are few lenders in the middle market able to originate and hold deals between $100 million and $200 million. Certain private equity sponsors are willing to pay a premium for certainty of close and to avoid the risks, additional work and potential for market flex, associated with the loan syndication even in this market, which has abundant liquidity.

The one-stops that we did with ISG Services and AdVenture Interactive are a deal candidates to be back-levered in future quarters. In the back-levered transaction, we take advantage of the floppiness of the market, and the demand from the banks for senior loans. These capabilities to originate and syndicate a back-levered transaction is a direct result of the growth in Fifth Street’s balance sheet, the quality of origination and underwriting platforms, and our dual investment grade credit ratings.

Only a handful of participants in the middle market are capable for originating and structuring some more investments. Competing for larger deals may lead to greater volatility in our gross originations, and net investment income per share in the short-term. However, in the long and medium term, we expect to have attractive lead structured and priced assets.

The current trough in the markets is allowing us to improve the diversity and flexibility of our liability structure at a lower cost of capital with longer-term maturities.

In the March quarter, we issued 15-year unsecured notes at 6.18%, our second baby bond offering and are working to increase the size and improve the terms on our secured bank and credit facilities.

Baby bonds are attractive and flexible sources of long-term capital and it compliments our existing short-term bank credit facilities. We can access unsecured debt markets today at very attractive rates because of our two investment grade credit ratings.

In the future, this may allow us to acquire and fund attractive assets that other investors cannot effectively lever. To the extent possible, both our equity and debt raises will be timed to minimize the gap between rising deploying capital to minimize earnings dilution for our shareholders.

Our overall portfolio of credit quality is healthy with about 98% of the portfolio ranked 1 and 2. However, one new asset Eagle Hospital Physicians was conservatively placed on non-accrual as we work out terms of restructuring.

To note, we placed things on non-accrual in a conservative manner, while many of peers do not do so, even with an OpEx security. We believe that we should not charge the shareholders any fees on income that we’re yet uncertain to receive. And we believe by doing this, we differentiate as being extremely shareholder friendly.

At this time however, we are comfortable with the fair value mark on Eagle Hospital Physicians. Yesterday, we announced that we entered into a definitive agreement to purchase Healthcare Finance Group or HFG.

HFG is the oldest continuously operating standalone asset-base lender in the United States. We believe HFG has built an impressive platform providing asset based credit facilities and term loans to a diverse group of healthcare providers. These credit facilities utilize a proprietary and scalable software platform, which differentiates HFG from its peers.

Our private equity sponsors in healthcare industry are looking for sources of ABL financing, which should provide opportunities for HFG to grow its $270 million loan portfolio as of May 6, 2013.

HFG should also benefit as a portfolio company of Fifth Street due to our relationships with key lenders to the ABL market. We expect this transaction to be modestly accretive to NII once completed and consistent with our track record of successful investments in the healthcare sector.

Through HFG, the range of products that we offer to our private equity sponsor clients is broadened to include asset-backed credit facilities, and term loans in the healthcare sector. We are evaluating other potential investments that will create incremental value when combined with our institutional platform.

Alternative lenders like Fifth Street with over 50 employees and deep relationships with banks, sponsors, and institutional systems in place, are well positioned for potential platform extensions, both in and outside the BDC.

Before I hand the call over to our President, Bernie Berman, I want to congratulate the employees and partners of the entire Fifth Street organization on their 15 year anniversary of lending to middle market companies and our upcoming 5 year anniversary as a public BDC in June.

Over the years, Fifth Street has grown into one of the leading middle market lenders serving small and mid-sized businesses in the United States.

And now, I will turn the call over to our President, Bernie Berman.

Bernard D. Berman

Thank you, Len. At Fifth Street, we are focused on maintaining a diversified, low-cost and flexible liability structure. We believe a mix of bank debt and longer term unsecured debt is a prudent way for a BDC to increase leverage.

In April and May, we issued $86.3 million of 6.125% 15 year unsecured notes with a par value of $25 per share. Subsequent to the end of the quarter, we increased the committed capacity of our ING led credit facility to $445 million from $425 million after an existing lender increased its commitment. We were in discussions with both new and existing lenders to increase the committed size of this credit facility.

We currently have total debt capacity of $1.3 billion, including $795 million through our ING, Wells Fargo and Sumitomo credit facilities, $276 million of unsecured debt and $225 million of SBA debenture capacity. We continue to work on reducing our cost of capital as well as improving the terms of and our access to debt capital.

In March, Fifth Street Mezzanine Partners V, L.P., our second SBIC subsidiary had the pricing fixed on $32 million of outstanding debentures at a rate of 2.351% per annum for 10 years. As a result, the total debentures outstanding in connection with both of our SBIC licenses increased to $182 million with a blended coupon of 3.355% as of March 31, 2013.

At quarter end, our second SBIC subsidiary had $43 million of available capacity remaining. Leverage at the end of the March quarter increased to 0.45 times, excluding SBA debentures. Pro forma for the April and May debt and equity offerings leverage would be 0.34 times, excluding SBA debentures. We continue to target leverage of 0.6 to 0.7 times debt to equity, excluding SBA debentures.

I’m now going to turn it over to our CFO, Alex Frank.

Alex Charles Frank

Thank you, Bernie. We ended the second quarter of our fiscal 2013 with total assets of $1.82 billion, an increase of $170 million or 10% quarter-over-quarter, reflecting nearly $340 million of new investment fundings. Portfolio investments were $1.75 billion at fair value and we had available cash on hand of $38 million.

Net asset value per share was up $0.02 to $9.90 at quarter end. For the three months ended March 31, 2013, total investment income was $54.7 million. The level of gross payment-in-kind interest, a key indicator of earnings quality, remained a low percentage of total income at 7.3% of total investment income, which is lower than the majority of our BDC peers.

On a net basis, cash collected from previously accrued PIK interest, actually exceeded PIK accruals by $200,000. We have noticed a number of our peers report net PIK, not gross PIK. Our net PIK income in the quarter ended March 31, 2013 was actually negative. Net investment income increased 28.6% to $29.3 million for the quarter, as compared to $22.8 million in the same quarter the previous year. We exited seven of our debt investments during the quarter, all of which were exited at or above par. The performance of the portfolio was stable as net realized gains were in excess of net unrealized losses, which resulted in an increase in net assets of $2.5 million for the quarter or 0.1% of the investment portfolio.

The weighted average yield on our debt investments declined to 11.4% with the cash component of the yield making up 10.5%. The average size of a portfolio debt investment increased from $20 million at the prior quarter to $21.1 million at March 31, 2013. We had gross originations of over $360 million in the quarter in 15 new and four existing portfolio companies, bringing the total companies in our portfolio to 97 at March 31, 2013. This compares to $144 million of deal closings in six new and four existing portfolio companies in the year ago period.

During the quarter, we also received $141 million in connection with the exits of seven of our debt investments. Approximately, 96% of the portfolio by fair value consisted of debt investments, 64% of the total was in first-lien loans up from 62% last quarter and 74% of the debt portfolio was at floating interest rates.

The investment portfolio continues to be well diversified by industry sponsoring individual company. Our largest single industry exposure continues to be healthcare, including pharmaceuticals at 22% of the total portfolio. The largest single individual company exposure is 6.4% of total assets and our top 10 investments represent 31% of total assets.

The investment portfolio continues to be of high credit quality and the credit profile was stable versus the prior quarter. We rank our investments on a one to five ranking scale and the highest performing one and two rank securities or 98% of our portfolio, which is relatively flat versus previous quarter and year ago period.

During the quarter ended March 31, 2013, we had three investments in the portfolio with only one with a fair value over $1 million Eagle Hospital Physicians on which we had stopped accruing income as compared to one at September 30, 2012, and four at March 31, 2012. Our Board of Directors has declared monthly dividends for June of 2013 through August of 2013 of $9.58 per share reflecting a continuing annualized rate of $1.15 per share.

I’ll turn it over to Dean.

Dean Choksi

Thank you, Alex. As new investors look at the BDC sector, one of the first questions they often asked is how BDCs pay higher dividend yields relative to coupon and other investments like high yield bonds and leverage loans.

Today, I’m going to briefly discuss some of the ways BDCs generate a premium yield relative to other credit assets. There are about 40 publicly traded BDCs with most of them investing in corporate credit. These BDCs can be split into two types; one, BDCs that primarily buy assets, and two, BDCs that primarily originate assets.

BDCs that buy assets are participating in syndications with other investment banks and BDCs. Their business model is closer to a traditional closed-end fund, because they are investing in larger deals originated by other institutions. Their assets typically have lower yields since they lend to larger borrowers in more liquid credits. Buying assets from other institutions also implies a limited ability to influence structure, terms, and conduct diligence.

On the other hand, we believe BDCs that have an origination platform have the ability to earn higher risk adjusted returns over time for the following reasons. One, sponsor relationship, many sponsors view their lenders as partners rather than the cheapest source of capital and pay a premium to work with lenders who understand their business, knowing which sponsors to lend to is a way for BDC to reduce risk.

Two, ability to underwrite and perform diligence; in self originated deals, lenders often work directly with the sponsor during their due diligence period. In the broadly syndicated market, diligence is partially outsourced to investment banks, reducing the time period for lenders to perform diligence.

Three, structure, terms and documentation; this is also controlled by the lender through negotiations with the borrower and sponsor. At Fifth Street, we view our expertise in structuring and legal documentation as a core competency and a means to protect our interest as a lender.

Four, attractively priced leverage; BDCs utilize modest amounts of leverage to enhance returns. The cost of debt available to a BDC differs depending on the underlying portfolio, performance and track record, institutional platform and diversification, all of which are taken into account by the credit rating agencies when they sign credit ratings to a BDC. BDCs that are investment grade rated like Fifth Street can effectively borrow at lower rates from banks and lend to unrated borrowers at higher rates. Successful BDCs develop relationship with sponsors, conduct extensive diligence and structure loan terms and documentation to protect their interest as a lender.

Collectively, these attributes enable Fifth Street and other leading BDCs with origination platforms to generate higher returns than more traditional credit assets like high yield bonds and leveraged loans, but with relatively less risk. Thank you for participating in today’s call. Caroline, please open the line for questions.

Question-and-Answer Session


Okay, thank you. (Operator Instructions) First question comes from the line of Robert Dodd from Raymond James please go ahead.

Robert Dodd – Raymond James

Hi, guys. Two kind of general questions, first on the status of the portfolio; obviously competition has shifted. We know that leverage multiples are moving up to the upper end of the market sector. I mean, looking at the weighted average leverage ratio of your portfolio, 41 versus 39 at the end of September. I mean that’s a fairly decent size tick up. And if we look at the level 2s, for the quarter versus 4, how much of that is an artifact of the result of portfolio company performance versus your new originations being at significantly higher leverage attachment points?

Bernard D. Berman

He’s a little bit – he’s creped up.

Len Mark Tannenbaum

Hi, Robert. I think part of it is the fact that two of these things ones stops, when you do one stop transaction. I think it’s a bit deeper in the structure because it incorporates both, the second lien and first lien in sort of a rolled together transaction. So the combination of the two even though it’s a first lien loan all the way through that we control. It could be 4.5 times or 5 times leverage. And I think because we did two large deals, that was primarily the reason that it up ticked.

Robert Dodd – Raymond James

Okay, got it. To kind of follow in on from that to the back levering question, I mean obviously it makes some sense to do some of those larger deals at lower coupon, leverage et cetera provided, you can shift off that first out piece.

Leonard M. Tannenbaum


Robert Dodd – Raymond James

Could you give us some color on where you stand in that process?

Leonard M. Tannenbaum

We can shift them out whenever we want, which is the good news. The demand from the banks for that senior piece is just voracious and the pricing is great. But we’re balancing it against our uses of capital and until we’re more drawn, you think of it as an ability to release some pre-available capacity when we need it. And right now, we don’t need that capacity. We’ve plenty of capacity under the credit facilities.

Robert Dodd – Raymond James

Okay, got it. I appreciate that, guys. Thanks.


Thank you for that question. The next question we have comes from the line of Greg Mason from KBW.

Greg Mason – KBW

Great. Good morning, gentlemen. Could you talk about your new acquisition of the Healthcare Finance Group? You said that was going to be accretive, but can you talk about the ROEs that you expect on that business and then if available, kind of what the purchase price was of that $110 million multiple of the equity that you paid for that?

Alexander C. Frank

Here Frank, hey, Greg. The transaction has not closed yet. As you know, we just signed the purchase agreement and we are bound by confidentiality agreements with the other parties. So we are limited in what we can say beyond what we’ve already said and that we do expect to be accretive to earnings. When we do close the transaction, we are happy to give you more specifics on the structure and the details.

Greg Mason – KBW

Okay, great. And then, Len, could you talk about just with a lot of other BDCs clearly showing slower origination activity in the first quarter, you said that you wanted to buck that trend and obviously put on record originations. Is there anything that could, should cause us to be concerned with most of the other peers, obviously, slowing down, you guys are speeding up. Are you giving up anything in terms of underwriting standards or coupons or anything to win these deals and what appears to be a slower first quarter environment?

Leonard M. Tannenbaum

I don’t know that I said I’m speeding up, I said that I’m not afraid to invest in this environment. There are a number of deals, a lot of deals, especially in the second lean loans that are falling below 9% and I just – I think that’s silly to do even if the companies are relatively safe. So we’re passed on a lot of loans.

In fact, it’s very frustrating when these loans tighten the way they are tightening in the upper middle market. The way we are winning loans is by thinking a little bit outside the box that loans at the CLOs can’t play in because the CLOs are now back to a factor, the loans at the closed end fund, the floating rate closed end funds can’t play in because they are a big factor in terms of buying these loans.

So when the market is zigging, you have to zag and by investing in assets where, for example, we may look at, we’re looking at two deals where is a large preferred component. Now the preferred in both of those deals is just as good as that, because the debts are very limited for different reasons. And so if we invest a little bit extra in preferred at cash coupon yields, remember, I don’t like these OpEx security things that others of my peers do because I think it’s very low quality of earnings and of course they can’t default, which are on the cash pay preferred. I think that’s a very interesting way to do it and can’t have the CLOs, can’t really play there. These smaller BDCs really don’t want, can’t have that preferred as a percentage of their assets go up. And if you notice our asset quality, 96% of our assets are debt, only 4% are equity and I’ll make the argument that this preferred is not even really equity, it’s really unsecured debt. So we have some capacity and flexibility in our balance sheet just because we’ve been so conservative in the past, we’re able to play in some sectors that others can’t.

Greg Mason – KBW

Great, thanks.

Bernard D. Berman

Following additional questions, I want to clarify something I said earlier, leverage at the end of the March quarter increased to 0.54 times, excluding SBA debentures.

Greg Mason – KBW

Thanks, Bernie.


Thank you. (Operator Instructions) We have another question and it comes from the line of Jon Bock from Wells Fargo Securities. Please go ahead.

Jonathan Bock – Wells Fargo Securities, LLC

Good afternoon and thank you for taking my questions. Len, starting first, just in terms of the large new investments to put on the books, and I noticed that AdVenture Interactive had been a deal that you had on the book as of 12/31 and obviously it was [95] yield and then you stepped in and refinance the entire, imagine it, significant portion of the capital structure, maybe walk through how being, I guess, in saying incumbent lender and using the platform strength that you now offer kind of led to refinancing a much larger piece than debt that you had on the of the same debt that you had on the balance sheet a quarter ago?

Leonard M. Tannenbaum

Yeah, thanks for the question. So we had a $15 million piece of a last out participation in the loan and because we’re already up to speed on the loan in conjunction with the sponsor, it really being up to speed on the company. It was easy to come back to us when we proposed to one of our good equity sponsor partners that we could do the entire thing as a one-stop and create more flexibility for them in doing so.

So because we were in the loan, it gives you the opportunity to then expand and take a larger piece. And then, as you saw, we did that with two sponsors. I will say it’s taken us about six months to convince our equity sponsors that we can do the over $100 million loans, otherwise we would have done them earlier. But now that we’ve closed two of them, we’re definitely being considered for a number of that size.

Jonathan Bock – Wells Fargo Securities, LLC

Thank you for the color. And looking at AdVenture or ISG in terms of whole size, can you maybe talk about what’s you’re targeting for an all-in IRR, obviously, we look at 6.8% and while that’s low, people do value the fact that it’s first lien term. But it would it be your point that perhaps 6.8% yield in a 2 and 20 structure is a bit less efficient and you’d either be looking to syndicate or I think to Bob’s early point backend lever several of these larger lower yielding transactions.

Leonard M. Tannenbaum

Let me just clarify what the yields of those two securities are. So one of them is 8% and one of them is 9% and that doesn’t include the point upfront or any extra fees that we’re getting as administrative fees. So they’re ready and they are both LIBOR flooding, so maybe interest rates will increase some day and they’ll even yield more. So we can turn it 8% or 9% yield in these two cases, which already have IRRs about 10%.

We believe, we can turn those into double-digit just buyback levering even just two turns of the capital structure very conservatively because that leverage demand from the banks is, as I said before, very aggressive. So I rather do that and create a last-out piece while controlling the whole structure and getting 10%.

And if you see people buying it at last-out pieces, they are getting the same thing as we just did on these two one-stops. So, we feel good about the pricing of both of these. But I agree with you, Jon, some sort of 7.5%, that model starts breaking down in terms of generating enough fees, but 8% or 9% as these loans are, I think we have a lot of leeway.

Jonathan Bock – Wells Fargo Securities, LLC

That makes total sense. And then maybe just one clarification as it relates to HFG and it is tied to kind of what’s in the release, it stated that you were likely going to structure this as a portfolio company instead of consolidating those assets on the balance sheet.

Can you may be walk through some of the reason as to why that would be the case because from an investors perspective they would likely be looking at paying you the external management fee of 2 and 20 to garner access to the middle market.

I’m pretty sure also investors wouldn’t be interested in paying another team fee for access to another set of credits within the middle markets, maybe just go beyond and talk about your reasons as to why it’s a portfolio company and not a consolidated party or potential balance sheet in the future?

Alexander C. Frank

Jon, this is Alex. What we said is we intend to manage it as a portfolio investment and we do and it will operate independently. But as Bernie said earlier, we just signed the purchase agreement and we haven’t closed yet. We’re bound by confidentiality and we haven’t finalized the structure around the ultimate transaction and investment. So we really can’t comment on that right now.

Leonard M. Tannenbaum

And with regards to fees though Jon, I can’t comment on that part. Regardless of how it’s structured, I personally believe that you don’t add these types of assets, which are low yielding assets, even if they were to be consolidated. You can’t charge 2 and 20 on gross assets on this type of asset. So in the case of where we would consolidate this type of purchase, we would raise the fees on the gross – on the debt and we would only charge fees to our equity investment.

Jonathan Bock – Wells Fargo Securities, LLC

That makes sense. Thank you.


And with that question, that concludes your questions for today, ladies and gentlemen. I would now like to turn the call back over to Dean for closing remarks.

Dean Choksi

Thank you for joining us on today’s call. Have a good day.


Thank you for your participation in today’s call. Ladies and gentlemen, you may now disconnect. Have a good day.

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