On April 7, 2011, mid-range Business Development Company (or "BDC") Fifth Street Finance (FSC) announced the private placement of $150mn of Convertible Senior Notes. The coupon is 5.375%, and the maturity is five years out in 2016. With the $22.5mn add-on offering, Fifth Street could raise $172.5mn from this source. Here are further details from the press release:
"The convertible senior notes are unsecured and bear interest at a rate of 5.375% per year, payable semiannually. In certain circumstances, the convertible senior notes will be convertible into shares of Fifth Street's common stock at an initial conversion rate of 67.7415 shares of common stock per $1,000 principal amount of convertible senior notes, which is equivalent to an initial conversion price of approximately $14.76 per share of Fifth Street's common stock, subject to customary anti-dilution adjustments. The conversion price is approximately 10% above the $13.42 per share closing price of Fifth Street's common stock on April 6, 2011. Fifth Street will not have the right to redeem the convertible senior notes prior to maturity. The convertible senior notes will mature on April 1, 2016, unless repurchased or converted in accordance with their terms prior to such date.
Fifth Street intends to use substantially all of the net proceeds from this offering to reduce outstanding borrowings, make investments in small and mid-sized companies in accordance with its investment objective and strategies and for general corporate purposes.
What This Means for Fifth Street
We've commented on Fifth Street's capital structure before. We've been impressed by the company's ability to raise both SBIC debt and two revolvers from different banks, but were worried that the revolvers both matured in the same year (2014). Here's an extract from our earlier post:
" ... we like to see borrowing maturities spread out to avoid having an unsustainable amount of debt called at an inopportune time should there be a credit crunch in our future. It may be hard to imagine today, but in a future crisis, lenders may not want to renew their credit lines at any price; having the bulk of your financing coming due at the same time is a recipe for potential disaster."
With the new Convertible Notes due in 2016, Fifth Street has gone a long way toward laddering its liabilities, and has done so at a reasonable price. Moreover, this is a major offering by size. The $172.5mn borrowed is greater than all the net debt on the balance sheet (that's the revolver outstandings and SBIC loans, less $43mn in cash) at the 2010 year end.
FSC has repeatedly indicated that its target debt to equity is 0.6 to 1.0. Using the year end GAAP equity for the company, that suggests total debt could reach $345mn. If we assume further that FSC will fill up on its SBIC lending capacity of $150mn, and we add the $172.5mn in Unsecured Notes, revolving debt will only be $22.5mn of the debt on the balance sheet. Or put another way, the bulk of Fifth Street's debt capital will be 5 year and 10 year (SBIC), fixed at low rates, which will probably average at under 5.0% per annum. From a risk management standpoint that's a much stronger structure than $150mn of SBIC and the remainder in revolving debt. (Of course we're not including the $127mn in new equity which the company raised in February, so these calculations are a bit out of date, and will need to be updated when the next earnings report rolls around).
Bring on Higher Rates!
As management has made abundantly clear, Fifth Street is hoping that with this inexpensive debt underpinning its finances, its emphasis on booking ever greater proportions of floating rate loan assets will result in superior earnings growth when interest rates rise. We like to quantify such item, so here goes: If LIBOR interest rates rise by 1% on $172.5mn of floating rate loans funded by the new Convertible Notes, and if we assume 20% of the benefit will go to FSC's Manager as part of the Incentive Fee, the shareholders will make an additional 2.5 cents a share each annually. Multiply that by however much you think interest rates are going to go up. We're not saying that will be the only benefit of higher interest rates on FSC, just the amount specifically benefiting from this new debt arrangement.
No Free Lunch
However, there's no free lunch. By choosing to add the Senior Notes, which will repay the revolver debt outstanding, Fifth Street's debt service costs will initially increase. The Revolver debt, when undrawn commitment fees are figured in, is costing the company only about 3.5% per annum. The new notes are at 5.375%. The higher rate will cost Fifth Street $3.2mn in higher interest expense annually. That's about 6 cents a year per share.
Another potential drawback may occur when and if the notes get converted at a 10% premium to the current stock price. The new shares issued will join the 67.5mn shares already outstanding (including the shares issued in the February 2011 equity offering) , and will pay an implied yield of 8.7%. Everything else being equal, and until Fifth Street re-leverages the new equity that will have been created, the existing shareholders will be diluted. However, given that Fifth Street is comfortable paying a dividend above its current earnings level this should not cause a drop in the current distribution level.
We're impressed with Fifth Street Finance's sophisticated capital management strategy, both in its ambition and execution. Keeping capital costs as low as possible, while maintaining a balance sheet that can absorb future credit and market shocks, is a critical feature of running a successful BDC. On a smaller scale, Fifth Street seems to be taking a leaf out of Ares Capital's (ARCC) book. The latter has been the market leader in raising unsecured debt and convertible debt on good terms and reducing its reliance on revolver funding. There is always a trade-off involved as discussed above in higher interest cost now for an undefined benefit in higher income and more resilient balance sheet in the future, but it's a path worth taking in the BDC Reporter's opinion.