Deconstructing Fifth Street Finance's Newsletter

| About: Fifth Street (FSC)

Yes, here’s another story about Fifth Street Finance (NYSE:FSC), whose PR department is working overtime. FSC issues a monthly newsletter in months without an earnings release, and serves as reporting-lite to information hungry investors. It’s more marketing tool than disclosure because content is self selected, but we have to take a look. Our conclusion: despite all the cheer leading it’s something of a mixed bag.

New Business Activity: FSC is quiet on new business booked in the calendar IIIQ of 2010 (their fiscal fourth quarter), but claims $63.5mn in new deals originated just since October, and $51mn already funded. More deals will be booked later in the quarter as part of the much mentioned rush of deals aimed at getting ahead of new capital gains tax rates, but FSC did not speculate on the dollar amount involved. To put the new deal activity, FSC booked $56.3mn in new business in the quarter ended June 30,2010, so this is a good start from that perspective. However, no words on repayments either last quarter of to date this quarter, so it’s hard to know if the loan portfolio is growing or not. We suspect that it is.

From a credit standpoint, we’re surprised (in a good way) that 95% of the loans are first lien, rather than the more traditional mix of secured and mezzanine debt which most BDCs have to book to achieve appropriate Return On Assets (“ROA”). Maybe this is accompanied by lower yields as would seem logical but the newsletter is moot on that subject. FSC may be spooked by the troubles in its loan portfolio (more on that below) and is seeking lower risk assets.

Capital Availability: The newsletter indicated FSC has “substantial capital available” to fund new business, which has been said before. The newsletter reiterated the news we covered a few days ago about fixing SBIC debt at very low rates.

The only new “news” in this area is that FSC (which has hardly been a borrower under its two Revolving loan agreements) is in discussions with both lenders to increase borrowing limits. This sounded more preliminary than a done deal. Let us quote: “...we have begun conversations with our lending groups that lead us to believe that both of our credit facilities can be expanded when additional capacity is needed”. We don’t see why that should be a problem for FSC which has been perennially under-leveraged. At June 30,2010 the Company had three times as much cash as debt on its balance sheet and its revolvers were languishing untouched.

Earnings Guidance: This is a tricky business and Fifth Street has been wrong before. A few weeks ago (on August 4th) the Company gave guidance for the quarter ended September of $0.20-$0.25 per share of Net Investment Income Per Share. In the newsletter, and with the books closed (but still being counted) FSC narrowed the range to $0.22-$0.25.

The crux of the issue,though, is that earnings have not yet bounced back to the levels achieved earlier in the year, or even last quarter ($0.26). The dividend announced for the quarter to end December 31 2010 is 32 cents, so earnings have a ways to go to cover distributions.We’re not overly concerned that the drop is permanent because of the under-leveraging of the Company referred to earlier. Still, we’ll be interested to see when management expects earnings per share to meet its dividend obligations. It’s unlikely to be in the ongoing quarter, and we may have to wait until the flood of new deals we’ve been promised have been booked , which means the second fiscal quarter (i.e. quarter ended March 2011). Taxable Income is probably ahead of Net Investment Income so the gap between earnings and dividends may not be as huge as it seems.

Credit quality: Here the newsletter was vague. Again, we shall quote: “Portfolio credit quality problems continue to be centered in the 2007 vintage and we are actively working to address all of our more challenging investments”. That just begs more questions. However, FSC pointed out that overall EBITDA earnings of the portfolio continues to move up, which is encouraging.

Credit is Job 1 at FSC. The Company has ample equity capital, an ever increasing lower middle market portfolio , a growing staff of professionals (FSC has just opened an office in the Chicago market and hired a local industry veteran), low priced financing etc. However, credit underwriting has been less than stellar. Out of 36 portfolio loans on the 10 have had to be restructured or re-priced. That’s over 25%. Moreover, 6 loans are non-accrual or cash interest or Pay In Kind interest or both, up from 4 the prior quarter. At a time when most BDCs are reporting ever lower troubled loans FSC has been headed in the opposite direction. Loans at fair market value in the 3 lowest internal investment quality ratings which FSC publishes are up 29% in just 3 months and now reach $31mn. These are not insurmountable levels but it’s hard without more disclosure to get our arms around the problem and to determine if credit should be expected to get worse or better over the next few quarters, especially where the “2007 vintage” loans are involved.

Like many BDCs which have raised substantial capital which remains unspent, Fifth Street is a work in process with success uncertain because of its short history, and the fast expanding nature of its loan portfolio, staff and strategy. The downside here is limited due to the low borrowing levels, the access to long term, cheap SBIC monies and the increasing focus on secured first lien loans, but the upside remains dependent on that hard to evaluate variable: the quality of loan underwriting. FSC is almost exclusively a lender (99% of assets) so the next few quarters will show if it has been able to balance the need for yielding assets with good credit practices.

Disclosure: Author is long FSC