What Fifth Street's Tannenbaum Said on Bloomberg TV

Includes: FSC, HTGC, TICC
by: Nicholas Marshi

Whatever else, Fifth Street Finance (ticker: FSC) is skilled at staying in the news. So here’s another item on the lower middle market Business Development Company (“BDC”) just 48 hours after we wrote about FSC’s news release concerning its bargain basement SBIC pricing. This time we’re reporting on what CEO Leonard Tannenbaum had to say on Bloomberg television yesterday in a relatively long interview by business news standards.

Up front a caveat. We happened on the interview while channel surfing, and hastily began throwing down some notes. So there’s always the possibility we misheard something. Anyway, for what it’s worth, here are the highlights:

  1. Mr Tannenbaum was indicating that the foretold boom in buy-outs for the second half of 2010 (and therefore in financing opportunities for FSC and BDCs in general) was underway, with everyone seeking to close by year end. The goal: avoid higher capital gain taxes in 2011. The BDC Reporter has heard this elsewhere, and we’ll get a much clearer picture in the next few weeks as third quarter earnings season rolls round. For FSC, the suggestion seems to be that, after a serious hiccup in the second quarter when a number of deals did not close which usually would have closed, new investments will rise sharply in the third and fourth quarters (especially the latter).
  2. Mr Tannenbaum suggested BDCs would be seeking to raise more capital to fund the above mentioned flood of new deals. FSC, though, with “$400mn” of capital available did not need to raise any money.
  3. The interviewer asked if BDCs were taking the place of banks-stung by losses and worried about asset growth-in the financing of middle market transactions. Mr Tannenbaum said yes to that question. We don’t know if we agree. Banks continue to finance (for better or worse) middle market companies not involved in buy-outs, which is not an area that BDCs with their limitations on leverage and high cost structures can compete in. In the leveraged buy-out arena banks were not a huge factor before the Great Recession. However, this all happened so quickly we may have missed subtleties both in the question and the answer.
  4. The interviewer asked what happens when interest rates go up ? Was that a risk to FSC and the industry ? Mr Tannenbaum admitted that might be a risk but indicated FSC had recently swapped $100mn to hedge some of that potential risk. We found that interesting because FSC has very little debt outstanding ($73mn in SBIC borrowings is all we’re aware of) and none of it is LIBOR based. Generally BDCs have done a good job of hedging themselves (mostly by match funding assets and liabilities but also by use of caps and swaps) for interest rate risk. Neither FSC nor most of the BDCs we track seems in great danger of interest rate margin compression should LIBOR rates rise. In fact, several BDCs with floating rate assets funded principally by equity raises, would greatly benefit from a higher LIBOR as loan rates would increase with little or no offsetting interest expense increase. TICC Capital (ticker: TICC), Hercules Technology (ticker: HTGC) and FSC itself come to mind.
  5. Mr Tannenbaum indicated new buy-outs were being priced at 6-7 multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), which was high enough to attract wannabe sellers who’ve been sitting on the sidelines for two years as both earnings and multiples dropped. This is what happens in every cycle, but Mr Tannenbaum’s comments seemed to suggests that despite a weak economy and much uncertainty the leveraged buy-out business (of which BDCs are an integral component) was getting back to business as usual.

However Mr Tannenbaum mentioned at the close that the leveraged buy-out industry faced the challenge/opportunity of refinancing “$600bn” of collateralized loan obligations (“CLO”) in the next few years, which were used to finance many buy-outs in the expansionary period. For the moment that instrument of cheap finance has gone the way of the Dodo so BDCs (and others) will have an opportunity to assist in the coming refis. Again, this subject needed more discussion as CLOs were usually priced at very low rates during the good old days. Many borrowers will have interest rate shock if they borrow from the BDC sector, which is pricing itself mostly in double digit interest rates. We imagine most of that CLO debt will be paid off by sponsors selling the underlying companies. Indirectly that’s still OK for the BDC industry because many of the buyers will be private equity houses which will tap some portion of the needed debt financing from BDCs. And the beat goes on.

Disclosure: Author is long FSC and HTGC. No position TICC.