Fifth Street Finance Corp. (NYSE:FSC - News) announced that its wholly-owned subsidiary, Fifth Street Mezzanine Partners IV, L.P. (the "SBIC Subsidiary"), has received committee approval for a license from the United States Small Business Administration ("SBA") to operate as a Small Business Investment Company ("SBIC"). Fifth Street expects that the SBIC license will be issued following final action by the SBA Administrator.
The license will allow the SBIC Subsidiary to obtain leverage by issuing SBA-guaranteed debentures, subject to the issuance of a capital commitment by the SBA and customary procedures. Debentures are loans issued by an SBIC which have interest payable semi-annually and a ten year maturity. The interest rate is fixed at the time of issuance at a market-driven spread over U.S. Treasury Notes with 10-year maturities. Current SBA regulations would permit the SBIC Subsidiary to issue up to $150 million in debentures.
In addition, Fifth Street has applied for exemptive relief from the U.S. Securities and Exchange Commission ("SEC") to permit the exclusion of debentures issued by the SBIC Subsidiary from Fifth Street's consolidated asset coverage ratio. Similar relief has been granted to other business development companies, though there is no assurance that Fifth Street will receive exemptive relief from the SEC, final license approval from the SBA or a capital commitment from the SBA.
Leonard M. Tannenbaum, Fifth Street's President and Chief Executive Officer, stated, "We are very pleased that we have received committee approval for the SBIC license. This will provide a new source of leverage for funding investments as we continue to meet the strong demand for capital in the middle market."
"Our SBIC Subsidiary, Fifth Street Mezzanine Partners IV, L.P., will be able to utilize Fifth Street's origination, underwriting and portfolio management resources to invest in small businesses and help them succeed," commented Bernard D. Berman, Executive Vice President, Secretary and Chief Compliance Officer of Fifth Street.
Godot has arrived at last in the form of an SBIC license. FSC has been waiting for months for this $150mn in new capital. Obviously, the company's liquidity , already one of the best in the industry, improves with this new string to their bow.
We made a few calculations and came to the conclusion that the company should be able to nearly double its investment assets, and still have cash left over. At September 30 2009, FSC had $327mn in investment assets. On a pro-forma basis, and assuming the new $150mnn in SBIC debt, $50mn Revolver and use of $75mn of the $113mn in cash on the balance sheet, FSC's assets could reach $602mn.
The company is under-leveraged so the $150mn of SBIC capital, even when fully deployed, will not ring the over-leveraged warning bells. In fact, we calculate investment assets (not even including cash) will cover debt by over 300%. That's important because loans to lower middle market companies with average yields of 15.7% are going to have relatively high default rates so a conservative capital structure is required.
Unfortunately, like many others before them, FSC is asking the SEC for exemptive relief from the very sensible 200% minimum asset coverage of debt ratio. That's not a problem right now but leaves the prospect that Fifth Street could gorge itself on debt capital in the future, so we'll be watching.
Since we wrote the first draft of this article, the company has announced an increase in its dividend for the second quarter of their fiscal year (quarter ended March 2010) to 30 cents from 27 cents in the prior period. Certainly, the availability of the SBIC license must have given management confidence that both assets and earnings will increase in the next few months. We're usually not in favour of BDCs announcing distributions in advance of knowing what their earnings will look like, but the gap here is not too pronounced. After all, the company did earn 26 cents Net Investment Income Per Share in the quarter ended September 30, 2009.
Our main mission is to determine which BDCs are likely to maintain/increase their dividend and which are likely to cut them. Obviously, this second increase in as many quarters underscores that FSC's pay-out is secure and may grow further in 2010. Currently the yield on the new dividend annualized is 10.6%, which is a reasonable return for a company with growth prospects and a (still) conservative balance sheet.
Disclosure: Author holds a long position in FSC